Retirement benefits constitute a substantial part of many individuals’ wealth. IRAs and qualified plans such as 401(k)s (hereinafter referred to as “retirement assets” or “retirement benefits”) are extremely popular financial tools to assist individuals when planning for retirement. However, these tools are subject to complex tax rules. As a result, careful planning is imperative to ensure that a person’s retirement assets pass to the appropriate individuals or charities in a tax efficient manner. This objective is accomplished only with the establishment of an estate plan that effectively passes the retirement assets as the owner desires, maximizes the use of the estate tax credit and provides post-death planning opportunities to take full advantage of the ability to defer income tax. In addition, the governing document for the retirement assets should be reviewed to determine whether the retirement assets are subject to the default distribution rules set forth in the tax code (as discussed below) or, for example, a lump sum pay out.
The first step in ensuring an owner’s retirement assets will pass in accordance with his or her wishes is an appropriately completed beneficiary designation form for each retirement account or plan. While this may seem like an obvious step, many individuals fail to properly complete these forms. If an IRA account or a qualified plan has no designated beneficiary, the governing instrument will likely direct payment of the retirement benefits to a surviving spouse. However, if there is no surviving spouse or if the instrument does not direct payments to a surviving spouse, many retirement benefits will then be payable to the decedent’s probate estate. Under the tax code, an estate is not a “designated beneficiary.”
The likely result of making payments of retirement benefits to a “non-designated beneficiary” is an acceleration of income tax — due to the loss of the ability to defer distributions. Indeed, if a decedent dies before age 70 ½, the tax code states that retirement benefits must be distributed within five years after death. If the decedent was older than age 70 ½ at death, then assets may be distributed over the decedent’s theoretically remaining life expectancy based on the age of the decedent at death (which may be very short). On the other hand, if the decedent had named a designated beneficiary, distributions could be made (in most circumstances) over the beneficiary’s life expectancy. The result is a greater ability to defer income tax on distributions.
An appropriately completed beneficiary designation form should also take the decedent’s estate plan into consideration. For example, many individuals will establish a revocable trust that divides, at death, into two sub-trusts — a marital trust and a credit-shelter trust — for estate tax purposes. In such a case, the decedent’s revocable trust should generally be listed as the contingent beneficiary of any retirement assets with the spouse as the primary beneficiary. This technique provides the primary beneficiary spouse with two post-death planning options. The first is an opportunity to execute a disclaimer to cause the retirement assets to fund a testamentary trust or sub-trust. The second option is a spousal rollover which is discussed below.
If the intent is for a decedent’s retirement assets to fund a testamentary trust or sub-trust, the trust’s provisions must take the retirement assets into special consideration. First, the trust must qualify as a “see-through” trust to maximize income tax deferral on distributions. Second, to the extent that any retirement assets will fund a marital sub-trust, special provisions are required to ensure that the retirement benefits will qualify for the marital deduction. Finally, to the extent the retirement assets will fund the credit-shelter sub-trust, those assets should fund the trust through a special formula clause to ensure that the beneficiaries will not be taxed on the retirement assets in the year of the decedent’s death or upon funding the sub-trusts. If any of these trust provisions are not properly drafted, the trust beneficiaries could experience harsh income tax consequences. Moreover, if the decedent wants to leave his or her retirement assets to charity, the retirement assets should not be paid to charity through the trust.
If, on the other hand, a spouse or a non-spouse beneficiary is the direct recipient of the retirement benefits, such individuals must take specific action after the decedent’s death. If a spouse is a direct recipient, the spouse should be sure to consider rolling over any retirement assets into an IRA in his or her own name. While it may be best to accomplish the rollover through a trustee-to-trustee transfer (i.e., the transfer is made between financial institutions or within the same financial institution), the tax code generally provides a 60 day window to make the rollover if the retirement funds are distributed directly to the spouse. In limited circumstances, the IRS may be willing to waive the 60 day requirement upon good cause, but mere failure to timely act does not constitute “good cause.”
If non-spouse beneficiaries are designated as the retirement plan direct recipients, there are a variety of post-death steps that should be taken to maximize income tax deferral. For example, qualified plan assets may generally be rolled over into an inherited IRA. However, the IRS’ current position is that the tax code does not require a plan to allow a non-spousal rollover. Although Congress and the IRS have hinted at mandating that plans require a non-spousal rollover, as of now, beneficiaries will be subject to the terms of the plan as to whether a post-death rollover is permitted. If there are multiple beneficiaries of a retirement asset, the beneficiaries should consider dividing the retirement assets into “separate shares.” If this is accomplished by December 31 of the year after the decedent’s death, each individual beneficiary should be able to take distributions over his or her own life expectancy rather than over the life expectancy of the oldest beneficiary (which may occur if the retirement benefits are payable to a trust, unless separate sub-trusts can be established). The beneficiaries of inherited retirement assets should accomplish any rollovers via direct trustee-to-trustee transfers. Inherited retirement assets in the form of IRAs should be designated as “inherited IRAs” for the beneficiaries’ benefit.
The McGrath North Tax Group specializes in estate planning, estate and trust administration and post-mortem tax planning. If you (or your clients) would like help in tax and estate planning for your IRAs or 401(k)s, please contact us.