Planning with Retirement Accounts

In recent years, classic pensions (with benefits based on years of service and salary levels only) have become less popular, often being replaced by tax-deferred “defined contribution” plans, such as 401(k) plans, deferred-compensation plans and Individual Retirement Accounts (IRAs).  With regular contributions and smart investment, these accounts can help to ensure a comfortable retirement.  And, unlike a traditional pension, the benefits do not end with the worker’s death; anything left in the account can be passed on, fairly easily, to one or more beneficiaries.

Naming Beneficiaries

Beneficiaries are typically named on a form that you fill out when you first get the account, and you can usually change them later on by filling out a similar form. If you are married, your spouse may have to sign also if you want to name someone else as beneficiary. You may be able to name more than one beneficiary, and indicate the portion of the account that will go to each (so you could split an account between several children, equally or unequally, or give a portion to charity).

If you have completed the forms necessary to name a beneficiary for the account, it’s easy for the beneficiary to claim the account after you die, simply by providing the plan administrator with proof of your death and proof of his or her identity. (For this reason, you should keep copies of your beneficiary designations, and the name and phone number of the plan administrator, in a place where your beneficiaries will be able to locate it quickly after you are gone. If you don’t have this information, you may be able to get it from your employer’s human resources department.)  If you have not named a beneficiary at all (or if the named individuals have died before you), the account will pass to your heirs, but it will take longer and could require a costly probate proceeding.

Even after you have named beneficiaries, it is important to review that information periodically. If your family situation changes (someone dies, marries, divorces, etc.), it is very important to check the beneficiaries of all your accounts (not only retirement accounts, but also “pay on death” bank and investment accounts, and life insurance), and make any necessary changes.  For example, if you divorce but don’t remove your former wife or husband as a beneficiary, he or she may still get the account when you die.

Maximizing the Financial Benefit of Tax Deferral

One of the biggest financial benefits of these retirement accounts is that no tax is paid on the money before it is put in, or on the interest it earns, until a withdrawal is made.  Consider an IRA with a balance of $100,000, earning 5% per year; if no withdrawals are made, after 30 years the balance will have grown to over $430,000.  (By way of comparison, if the $100,000 was removed from the IRA and then invested at the same 5% rate, with taxes paid on the withdrawal and on the earnings every year at a 30% rate, at the end of 30 years the balance would only be $196,475.)

Thus, it is clearly a good idea for someone who has inherited this kind of account to leave the money in there for as long as possible.  Uncle Sam wants his tax bite, though, so the law requires that a beneficiary start taking the money out shortly after the original owner dies. The required annual withdrawals are called a “required minimum distributions” or RMDs.  Depending on WHO inherits the account, and how old they are, the money may have to be taken out very quickly, or may be able to be left in for a long time.  So, it is important not only to name a beneficiary for the account, but also to select the right beneficiaries. As a general rule, a younger individual beneficiary will be allowed to take smaller RMDs, and thus keep more of the money in the tax-deferred account for longer.  A 19-year-old beneficiary, who takes only the RMDs every year, would be able to take over $650,000 over his lifetime from an account that held $100,000 when he inherited it.  A 58-year-old beneficiary, on the other hand, would take only $194,000 from the same account.

In addition to the hassle of a probate proceeding, failing to name a beneficiary has another downside –  regardless of who eventually gets the money, it will most likely have to be paid out fairly quickly.  This will not only cause the beneficiary to lose the advantage of tax-deferred growth, but he or she will have to pay income tax on the larger required withdrawals, which could push the recipient into a higher tax bracket.

A Word About Trusts

In recent years, many people have become aware of the benefits of using a “revocable living trust” as a way to plan for their death or incapacity.  If you have such a trust, you have probably been advised to place many of your assets into the trust.  What about retirement accounts? A retirement account should never be owned in the name of a trust, but the trust could be named as beneficiary.

Is this a good idea?  It could be the best thing to do – or it could be the worst.  If you name your trust, or a trustee, as beneficiary, and the trust is not specifically designed for that purpose (most basic revocable trusts are not), the entire account balance may have to be paid to the trust within five years of your death, and the trust may then have to pay income tax on the proceeds at a very high rate (approaching 45%, when both Federal and State taxes are considered), leaving much less for the people who were intended to benefit.   For this reason, you should NEVER name your trust as beneficiary of a retirement account without first seeking advice from an experienced professional, who is familiar with the complex laws relating to retirement accounts and has reviewed the terms of the trust carefully.

Sometimes, however, if it is done properly, it can be very good to name a trust as beneficiary.   Why is this? Well, just because a young individual beneficiary can leave the funds in the account for a long time, taking only small RMDs, does not mean that they will.  The RMD law only establishes the minimum amount that must be taken out, it does not set a maximum.  Most of the time, a lump-sum payment option is available, and any named individual beneficiary over the age of 18 can simply empty the account immediately after the account holder’s death.  Many young people who inherit these accounts do just that, and in most cases, substantial taxes are paid and the remaining funds are spent rapidly.  (Consider the typical 19-year-old – if told that he can take a small payment every year, get over $200,000 by the time he’s 60 and still have over $250,000 left In the account, or can have $70,000 now, which do you think he’ll choose?)

Naming a properly prepared trust as beneficiary can allow you to put some limits on your beneficiaries’ access to the funds – either until they have reached a certain age, or by limiting the things they can use the money for, such as education, health care, buying a home or starting a business – while still obtaining the benefits of a long tax-deferral.  An experienced estate planner can help you decide if this solution is appropriate for you.

Charitable Options

Lastly, if you are thinking about making a charitable bequest from your estate, you may want to consider making that gift from a tax-deferred retirement account. Because the charity will not have to pay income tax on the money, this can maximize the total amount passed on to your loved ones, by cutting out the payments that would otherwise be made to Uncle Sam and the State Tax Department if retirement accounts were paid to individuals.

Published in: on August 23, 2010 at 10:07 pm  Leave a Comment  

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