Each year, retirement plans (IRAs, 401(k) plans, profit sharing plans, etc.) are subject to required minimum distribution (RMD) rules set by the Internal Revenue Service (IRS). These required minimum distribution rules are very complex and change depending upon the identity of the beneficiary of the plan. Distributions from a retirement plan are based upon life expectancies, which in turn are determined by tables published by the IRS. Because the distributions start at just under 4% at age 71 and then slowly increase, many retirement plans will continue to grow even after RMDs commence. While the distributions will eventually become larger, most individuals will eventually pass away with a retirement plan balance reasonably close to the value of their plan at age 70.
For this reason, the eventual distribution options for a retirement plan are quite important. For you and many other readers, the retirement plan may be the largest asset in your estate.
Retirement plans are transferred through a beneficiary designation that you make on your retirement plan custodian’s form. The five common choices for designated beneficiary are (1) the surviving spouse, (2) children, (3) charity, or (4) a trust for children or other beneficiaries.
The general rule of retirement plan distributions (if the owner of the retirement plan, or participant, was under the age of 70½ at the time of his or her death) is that the retirement plan must be distributed within 5 years of the date of the participant’s death. If the participant is over the age of 70½, distribution of the plan benefits is required to be made over the period of the participant’s life expectancy at the time of his or her death. If, however, the beneficiary of the retirement plan is a “designated beneficiary” (as defined by the IRS), the beneficiary can “stretch” distributions from the plan over his or her life expectancy, as designated by IRS schedules. Beneficiaries also have RMD rules, though they are different than those that apply to retirement plan participants.
1. Spouse as Beneficiary
The most common choice for a married couple is to select the surviving spouse as the designated beneficiary of a retirement plan. “Special” rules apply to spouses, and those rules are very advantageous for surviving spouses. When the retirement plan owner passes away, the surviving spouse has two choices with an IRA. He or she can receive payments under a one-life expectancy schedule or the IRA can be rolled over into his or her IRA.
Planning Tip: A spouse is a favored beneficiary under IRS retirement plan distribution rules. For a married couple, each partner should always consider naming his or her spouse as the primary beneficiary of a retirement plan.
Because the payments under the IRS schedule are frequently double the required payments with the rollover, nearly every spouse rolls over the retirement plan into his or her own plan.
Assume that Harry Smith is the IRA owner and he passes away with Helen Smith as his designated beneficiary. Helen is age 68 when Harry passes away and rolls over the IRA into her plan.
When Helen reaches age 70½, she must start taking required minimum distributions. The minimum distribution must be taken by April 1 of the next year and is just under 4%. Her distribution will steadily increase as she becomes more senior.
Because Helen rolled over Harry’s IRA into her IRA, she qualifies for the lower required minimum distributions under the uniform table. Helen often selects children or charities as designated beneficiaries.
If you are married and you plan to leave a qualified retirement plan (an ERISA plan) to a trust or other beneficiary that is not your spouse, then you must obtain a written consent from your spouse. This requirement does not apply to an IRA in non-community property states, such as Illinois.
If you are not married, or in cases where there is a blended family, a retirement plan, or a portion of a retirement plan, may be left to children or other beneficiaries.
There are two typical methods for designating children as beneficiaries. First, if each child receives a stated fraction of the plan, then each child may take distributions based on his or her own life expectancy.
Second, if there is a class designation with the IRA designated to a group of children or other heirs, then the age of the oldest beneficiary is used to determine the payouts.
It is best with several children to allocate a fractional share to each child. The opportunity to use the separate share method is quite important because of the payout calculation method. If a 60-year-old child is the beneficiary of an IRA, then he or she may take distributions over approximately 25 years. The distributions would start at age 61 at approximately 1/25th or 4%. Using a method of subtracting one from the denominator each year, the payments would steadily increase until the entire IRA is distributed at approximately age 86.
Planning Tip: When naming children or other individuals as beneficiaries of a retirement plan, take advantage of the separate share rules to allow each beneficiary to take plan distributions over his or her own life expectancy, rather than using the age of the oldest to determine distributions to all beneficiaries.
Does a beneficiary have to take the stretch payout? No, and frequently children do not. Many participants give their children an opportunity to stretch out the payouts, but this plan is often not successful. The children take higher distributions and thereby deplete the retirement account far more quickly. Approximately one-half of the children take the distribution early, even though that means paying the income tax earlier and losing the benefit of the tax-free growth for the life expectancy of the child. Parents who wish to encourage lifetime retirement plan distributions for the child may choose to use a testamentary trust to hold the retirement plan and pay out over the child’s life expectancy.
For the retirement plan owner, the retirement plan is a wonderful benefit and a very good asset. However, for children, the retirement plan is transferred with a large “you owe the IRS” tax bill attached (with the exception of a Roth IRA that is income tax free). For the vast majority of qualified plans, the child will pay income tax. Worse yet, the retirement plan distributions may even push the child into a higher tax bracket.
With the income tax payable on retirement plans and no income tax due on the distribution of real estate, land, stocks or cash, the retirement plan is a less desirable asset. In fact, many will consider this a “bad asset” because of the income tax on most retirement plan distributions to children.
For this reason, children often prefer to receive a home, land or stock because there is no income tax bill attached. Often a wise planning decision is to transfer the home, stocks or land (the good assets) to children and the retirement plan to charity (the bad assets due to the income tax bill to children).
Because charities are tax exempt, there is no payment of income tax or estate tax. The charity receives the full value tax-free. By transferring the retirement plan to charity, it is possible to turn a bad asset into a good asset.
Planning Tip: A charity is another “favored” beneficiary because charities receive retirement plan benefits income-tax free.
A very good plan for parents who want to provide for a charity is to combine a benefit to children with a future benefit to charity. This plan is called a charitable remainder trust.
A charitable remainder trust may receive the retirement plan with no payment of income tax. The full value of the retirement plan may be invested for a term of up to 20 years. Income earned is taxable and that new income is paid to children for the selected term of years. At the end of the selected term, the charity receives the trust principal.
For example, Mary Smith had an $800,000 estate. She lived in a home worth $200,000, had a CD for $200,000 and $400,000 in her IRA. Her IRA was substantial because when her husband Bill passed away, she rolled over his IRA into hers so the combined IRA is now half of her estate.
Mary has two children and decides to transfer the home and CDs to the children in equal shares when she passes away. They each receive $200,000 in value from the home and CDs with no income or estate tax.
After Mary passes away, the $400,000 IRA is transferred into a charitable remainder trust. It receives the IRA proceeds and invests the full $400,000. The trust pays 5%, which is divided between the two children for a term of 20 years. At the end of 20 years, the trust principal plus growth is given to charity.
Mary felt very pleased because she had achieved several goals. First, she had provided both principal and income to her children. This is a very good plan because some children will need a period of time to improve their money management skills. Second, she saved all of the income tax on the IRA. Because the charitable remainder trust is tax exempt, it receives the entire IRA tax free. The trust earns income for the children for a term of 20 years and is then transferred tax-free to charity.
Another option is to use lifetime distributions from a retirement plan to purchase a “wealth replacement” life insurance policy. In that way, the children can be made “whole” at the death of the participant and the entire retirement plan can be paid to charity.
4. Designating a Trust as Beneficiary
The rules that govern the distributions when a trust is named are a bit more complex than those that govern an individual beneficiary. A trust, in and of itself, is not a “designated beneficiary” under IRS rules and will not automatically qualify for “stretch” distributions. The trust must be specifically drafted to qualify for “stretch” treatment. A Revocable Living Trust (RLT) generally should not be named the beneficiary of a retirement plan, since most RLTs do not qualify for “stretch” distributions.
There are, however, several different types of trusts that can be designated as beneficiary of a retirement plan and qualify for “stretch” of the retirement plan distributions.
The first is a “conduit trust.” Properly drafted, a conduit trust can protect the inherited IRA from the claims of the beneficiary’s creditors, while at the same time providing for stretch distributions to that beneficiary. All distributions made from the retirement plan to the trust are immediately paid out to the beneficiary of the trust (and thus the term “conduit”).
For individuals with larger estates, it may make good sense to create a special retirement trust for the specific purpose of designating it as beneficiary of a retirement account. Such a trust can be drafted to accumulate distributions from a retirement plan that are then paid to the beneficiary as needed or as appropriate. Properly drafted, such a trust qualifies for “stretch” distributions for the beneficiary of the trust.
Planning Tip: Although retirement plan distribution planning with trusts is a bit more complex, it is often the only way that the overall objectives for the distributions can be achieved, whether for asset protection, stretch distribution, accumulation of plan benefits or a combination of several of these benefits.
When it comes to designating beneficiaries of retirement accounts, it is always best to consult a qualified estate planning professional. Estate planners understand the rules applicable to retirement plan distributions, especially when designating a trust as beneficiary. Those rules are very technical and unforgiving. The income tax consequences of making an incorrect designation can be dramatic.