Many people mistakenly believe that their Last Will and Testament or Revocable Living Trust will distribute their retirement plan assets at their death. As discussed below, in many cases this is a costly mistake.
HAVE YOU DESIGNATED BENEFICIARIES?
Retirement plan accounts, such as Individual Retirement Accounts (IRAs), 401(k), 403(b), and 457 plans, just to name a few, are types of assets most Americans will own at the time of their death. For many, retirement plan assets are the largest assets at the time of their death. Many people, however, are unaware that retirement plan assets require special attention when you are planning your estate.
YOU RETIREMENT PLAN, NOT YOUR WILL, CONTROLS THE DISTRIBUTION
In almost every case, your Last Will and Testament or Revocable Living Trust will not control the distribution and management of your retirement accounts. Instead, you must complete a “beneficiary designation” to ensure your retirement plan benefits pass to whom you want, when you want, and in the manner you want, after you die.
If you fail to complete and sign a beneficiary designation form for a retirement account you own, then the terms of what is called the “custodian agreement” or “plan agreement” will dictate by default where and how your retirement plan benefits will be distributed when you die. Every retirement account you own will has, in addition to the beneficiary designation form, a contractual agreement between you and the entity that is responsible for holding and, in some cases, managing your retirement plan assets. These custodial or plan agreements specify who will receive your retirement plan assets when you die if you fail to have signed a beneficiary designation form. In most cases, the result will not reflect your wishes or unique family situation.
FAILURE TO DESIGNATE BENEFICIARIES CAN BE COSTLY
If you let your retirement plan agreement decide who will get your retirement benefits when you die, there is a very good chance that the “default” beneficiary named in your retirement plan agreement will be your “estate.” Typically, if your estate is the primary beneficiary of your retirement plan when you die, the entire value of the retirement plan account will be subjected to federal income tax and state income tax (if applicable) in addition to your outstanding debts.
As a rule of thumb, whenever your estate is the beneficiary of one of your retirement accounts, at least 1/3 of that retirement plan account balance at the time of your death will be lost due to income taxation of your entire retirement account balance and payment of outstanding debts. This percentage can be much higher for some families. In many cases, this loss can be easily prevented simply by making sure you have completed and signed proper beneficiary designations for every retirement account you own prior your death.
WHAT IS “STRETCHING AN IRA” AND WHY IS IT IMPORTANT?
For many the most significant benefit of using IRAs and Qualified Plans is tax deferral. Money inside an IRA or Qualified Plan is not subject to income tax until it is distributed. This allows the money to grow and compound without deduction for taxes. Over time, this could result in millions in additional earnings in your Qualified Plan or IRA.
Unfortunately, the IRS has promulgated special distribution rules to prevent families from leaving money in a Qualified Plan or IRA over multiple generations, which would not be subject to taxes. These rules, govern when and how funds must be distributed from IRAs and Qualified Plans. Understanding the nuances related to these rules could save your family from paying significant unnecessary taxes.
YOU MUST WITHDRAW ON A CERTAIN DATE (USUALLY WHEN YOU ARE 70 ½)
In most cases, you must begin to withdraw funds from your IRA or Qualified plan on April 1st of the year after you turn age 70 1/2 (the “Required Beginning Date” or “RBD”). If you do not begin to take withdrawals by that date, the IRS will impose a penalty equal to 50% of the amount that should have been withdrawn (discussed below).
Of course, an owner of participant can make early withdrawals at any time prior to the Required Beginning Date. In general, withdrawals can occur as early as the plan participant/IRA owner turning age 59 ½ (without penalty or at anytime with a 10% penalty.
THE IRS RULES DETERMINE THE AMOUNT OF REQUIRED DISTRIBUTIONS
As mentioned above, you must begin to make withdrawals by a certain date. The amount of those withdrawals is referred to as “Required Minimum Distributions” or “RMDs.” The amount of the Required Minimum Distributions is based on (i) the maximum period over which distributions can occur without penalty; and (ii) the amount of money in the plan or account.
THE PERIOD OF TIME TO MAKE DISTRIBUTIONS (LIFE EXPECTANCY)
The longest period over which distributions can occur without penalty is the life expectancy of the Qualified Plan or IRA beneficiary. Life expectancies are set by the IRS and are based on whether an individual is single or married (and the age of the spouse if married).
As long as the plan participant or IRA owner is living, the determination is made from an IRS table which uses his or her age in the year the distribution is to occur and his or her life expectancy. However, if the plan participant/IRA owner dies before his or her interest in the Qualified Plan or IRA is entirely distributed, the maximum distribution period will depend on (i) whether the plan participant / IRA owner
died before or after the required beginning date; and (ii) whether he or she named a designated beneficiary for the remainder of the interest.
Life Expectancy if Death Occurs Prior to Required Beginning Date
The maximum distribution period if the plan participant/IRA owner dies before reaching age 70 ½ depends on whether a “Designated Beneficiary” was named to receive the balance of the interest. According to the IRS, a Designated Beneficiary are only individuals who are entitled to a portion of the plan participant or IRA owner’s benefit upon the death of the participant/owner, or other specified event. In some cases, a properly crafted trust will qualify as a Designated Beneficiary. If anyone other than an individual or qualified trust is named as a beneficiary, the participant/owner will be treated as having no Designated Beneficiary.
In the absence of Qualified Plan or IRA provisions to the contrary, the balance of the plan participant/IRA owner’s interest can be distributed over the life expectancy of the Designated Beneficiary. If there are multiple Designated Beneficiaries, the shortest life expectancy will be used.
If there is no Designated Beneficiary the balance of the owner’s interest must be distributed in full by December 31 of the fifth year after his or her death, thus incurring tax unfavorable consequences. This is known as the “Five Year Rule.”
Whether a life expectancy or the Five Year Rule is used Required Minimum Distributions must begin by December 31 of the year after the owner dies. There are special rules in the case a surviving spouse is named as a Designated Beneficiary.
Life Expectancy if Death Occurs After Required Beginning Date
If the owner dies after his or her Required Beginning Date, the maximum period over which the remaining balance can be distributed will also depend on the Designated Beneficiary (if any). In general, in this case, distributions can occur over the longer of the life expectancy of the owner or the Designated Beneficiary. There are special rules where there was no Designated Beneficiary.
STRETCH AN IRA OR QUALIFIED PLAN FOR TAX BENEFITS
Certain rules by the IRS currently allow a beneficiary to “stretch” out distributions over a period of time which results in the deferral of taxes (albeit temporary). The key to maximizing the “stretch” period is the rules related to inherited IRAs or Qualified Plans. A Qualified Plan or IRA is inherited if the person for whom it is maintained acquired his or her interest because of death of the original owner.
For this to work, the deceased must have completed a beneficiary designation form and properly re-titled the Qualified Plan or IRA. Incorrectly re-titling what remains of the owner’s interest can be a costly mistake – as the IRS could deem this action as a lump sum distribution to the beneficiaries. If the interest is deemed to be distributed the stretch – and the related tax savings – is lost.
There are other complex rules related to the spouse as a beneficiary (including rules related to rolling the Qualified Plan or IRA into the Qualified Plan or IRA of the surviving spouse) and designating multiple beneficiaries that are beyond the scope of this brief summary.