Retirement plan beneficiary designation forms are an important component of your estate plan. For many people, retirement accounts (IRAs, 401(k)s) are perhaps the biggest asset they own, second only to their house. As part of your estate planning, the beneficiary designation forms for your retirement accounts should be reviewed to make sure they are up to date. You may have named a beneficiary who is now deceased or you may have had a change of circumstances such as a marriage, birth of a child or a divorce. If you don’t name a beneficiary, the retirement plan may automatically distribute money to a spouse or children or to your estate. All of these options may result in unintended tax consequences with a portion of the account owed to the IRS for income tax.
When money is withdrawn from a retirement account, federal income tax is generally owed for the year it was withdrawn. In addition to ordinary income tax on distributions, if you take a distribution before reaching age 59 ½, you also may owe a 10% penalty on the distribution.
The best approach may be to take advantage of income tax deferral for as long as possible. By leaving the account intact and stretching out minimum required distributions over the life of a beneficiary, there will be more tax-free growth with income tax spread out over many years, leaving the investment to grow unhindered. The longer this deferral continues, the better, because, generally, the deferral of income tax increases the ultimate value of the benefits.
The first step to ensure a smooth transition is to name a primary and secondary Designated Beneficiary (a Designated Beneficiary is an individual who is designated as a beneficiary under the plan). That will ensure that the account is automatically turned over to someone after the owner’s death and will not be delayed in probate proceedings where it can take months and sometimes longer to get at the money. If there is no Designated Beneficiary, the payout options will generally be less favorable. Only individuals designated by the owner (or by the terms of the plan) qualify as Designated Beneficiaries. Estates, corporations, and LLCs do not qualify as individuals, although a Trust can qualify in some instances (as discussed below).
From a tax savings standpoint, your spouse is by far the best Designated Beneficiary you can name for your retirement account. Only the surviving spouse has the right to rollover a retirement plan, tax-free, into his/her name and become the owner with regard to those benefits under the minimum distribution rules. As the new owner, the surviving spouse has options not available to other beneficiaries, such as deferral advantages to delay the start of required minimum distributions. These distributions can be deferred until the surviving spouse reaches age 70 ½. The surviving spouse can also name another Designated Beneficiary and the payout after the surviving spouse’s death will be based on the life expectancy of the new Designated Beneficiary. This creates an opportunity for the account to grow and defer payment of income taxes for many years.
If you name someone other than your spouse to be the Designated Beneficiary, the rules for required distributions are different, although stretch-payouts over the life of the beneficiary are available. If a Designated Beneficiary is named and the owner dies before distributions started from the plan, then the account is paid out over the life of the beneficiary. In this case, the beneficiary receives the account as an Inherited IRA or Inherited 401(k). If you inherit a retirement account from anyone other than your spouse, you can’t roll it into your own IRA. You can retitle the account so it’s clear that the owner died and that the beneficiary has inherited the account. You should retitle the account so it reads like this: “John Jones, Deceased (date of death) IRA F/B/O (for benefit of) James Jones, Beneficiary.” After the beneficiary has retitled the account, the beneficiary can stretch out withdrawals over his/her lifetime rather than being forced to withdraw the funds sooner. The beneficiary must make withdrawals every year, with the first being made by December 31 of the year following the year of the original owner’s death.
If a Designated Beneficiary is named and the owner has already starting receiving distributions from the account, the account can be paid out over the life of either the owner or the beneficiary (as an Inherited IRA or 401(k)), whichever is more favorable.
If your retirement account does not have a Designated Beneficiary, or if the Designated Beneficiary is deceased, and the owner dies before distributions have begun, the account may be required to be paid out to the owner’s estate within 5 years of death. If the owner dies after distribution had begun, the account is paid out to the owner’s estate over the owner’s life expectancy.
There are some family circumstances where it is not advisable or appropriate to leave a retirement account outright to an individual. If you are leaving your assets to a minor or someone who is disabled, doesn’t handle money well, or is in jail, having a trust as beneficiary may be a good option, giving the trustee more control over distributions even though it may mean potentially higher taxes for the trust. Also, individuals with a taxable estate may decide to fund their credit shelter trust with retirement assets to take advantage of the federal estate tax exemption amount. Although a trust is not an individual, if the trust is set up correctly to meet the Internal Revenue Service’s requirements and also various rules are complied with, you can treat the individual trust beneficiaries as if the owner had named them directly as beneficiaries. This would allow the beneficiaries of the trust to stretch out distributions from the account over their lives to avoid a large income tax bill.