Tax-Saving Tips on Estate Planning for Retirement Accounts

Funds held in a tax-advantaged account often represent a large part of an individual’s net worth.  Because of special tax rules, such accounts must be carefully considered and analyzed as part of any comprehensive estate plan.

Individuals with a traditional IRA or a 401(k) account (“tax-deferred accounts”) must start taking “Required Minimum Distributions” (RMDs) at the age of 70 1/2.  When someone receives a distribution from one of these accounts, the distribution is taxed as ordinary income, subject to his or her individual tax rate (as long as there is no penalty for an early distribution).  On the other hand, because contributions to Roth IRAs are made after taxes, distributions from Roth IRAs are tax-free.  There are no minimum distributions for Roth IRAs.

Planning for tax-advantaged retirement accounts should incorporate two general principles.  First, as a general matter, the longer funds remain in either account the greater the tax savings.  Therefore, it is usually wise to delay withdrawals as long as possible.  This concept is often referred to a “stretching” an IRA or other retirement account.  Second, the tax advantages of a tax-deferred account depend largely on the tax rate of the recipient at the time the distribution is made.  Finally, planning is constrained by the prohibition against transferring either type of account.

These principles affect not only tax planning for retirement accounts during the owner’s lifetime, but also planning for how the retirement accounts will be allocated upon the owner’s death.  Because tax-deferred accounts are subject to RMDs, there will be little remaining in the account if the owner lives to his or her life expectancy.  However, as science hasn’t yet evolved to the point where it can tell us when our number will be up, we must make our plans in the context of uncertainty.

If a spouse inherits a tax-deferred account, the account can be rolled over into his or her IRA, such that RMDs would be calculated as if it were the spouse’s own account.  A spousal inheritance can defer any distributions until the spouse reaches age 70 1/2.  Depending on the spouse’s age, taxes on the account can be deferred significantly.

Non-spouse beneficiaries must begin taking distributions the year following the year in which the account owner died, and the account can be stretched over the life of the beneficiary, with RMDs based on the beneficiary’s life expectancy.  Accordingly, a young beneficiary will be able to stretch distributions out over a longer time period than an older beneficiary.  If an account names more than one beneficiary, the RMDs are calculated based on the age of the oldest beneficiary, unless the account is split by December 31 of the year following the year in which the account owner dies.  If the account is split, RMDs are calculated separately for each beneficiary based on his or her age.

What implication do all of these rules have for those planning for the inheritance of their retirement accounts?  First, it is preferable to leave the account to a beneficiary who is expected to be in a lower income tax bracket than one who is in a higher bracket.  Second, it is generally preferable to leave the account to a younger beneficiary than one who is significantly older, as this will yield the greatest amount of tax-deferral.  In other words, this will stretch the benefits of the retirement account.  If the account is left to multiple beneficiaries, the account should be split shortly after the owner’s death.

Finally, it is important to note that account beneficiaries that are not individuals, such as a corporation, partnership, and most trusts, are not “qualified beneficiaries” for purposes of the tax-deferral rules.  If an account is left to one of these entities, the transfer will be deemed a distribution of the entire account and trigger immediate taxation.  Therefore, in most circumstances it is best to name one or more individuals as the account beneficiary or beneficiaries.




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