Some Questions About Inheriting A Retirement Account

Will my beneficiaries owe taxes on the retirement accounts I pass down to them?

Most retirement accounts, including so-called “traditional” IRAs and employer sponsored 401(k) accounts, are funded with the pre-tax contributions of the plan participant (“Participant”).  When withdrawals are made from that account, whether by you or by your beneficiaries, the withdrawals will be taxed as ordinary income.  Unlike other types of assets that have a tax basis that is “stepped up” to the fair market value of the asset on the owner’s date of death, retirement plans do not receive that step up in basis upon the death of the Participant. 

However, withdrawals from a Roth IRA will be tax-free to the beneficiaries who inherit a Roth IRA.

Are all retirement accounts treated the same way?

In general, employer 401(k)s often have many more limitations and restrictions than IRA accounts.  One limitation that may be problematic concerns withdrawals from an inherited 401(k) following the death of the Participant.  The rules of many 401(k) plans require the beneficiary who inherits the Participant’s account to withdraw all of the money within five years (or sooner) from the death of the Participant.  Spouses are not subject to this requirement.  Inherited IRA accounts by contrast will typically allow withdrawals to be “stretched out” over the lifetime of the beneficiary (with some important exceptions addressed below).  Why is that important?

Remember that withdrawals from 401(k) accounts are taxed as ordinary income.  A requirement that the entire account be withdrawn within 5 years necessarily means larger amounts withdrawn in a given year as compared to much smaller withdrawals over a much longer period of time.  Due to the progressive nature of our income tax rules, those larger withdrawals will often result in a significantly larger income tax liability. The beneficiary may not need access to the funds in the account and would prefer to take only the required minimums. This does not preclude them from at any time in the future withdrawing greater amounts of the funds in the account.

Who should be named as the beneficiary of the plan?

The answer to this question depends on the goals and concerns of the Participant.  If a retirement account Participant simply wishes to keep the funds in the account out of the probate process, then that goal is accomplished by simply filling out the proper paperwork to designate a beneficiary.  Many married couples instinctively name the surviving spouse as a primary beneficiary and then their children as contingent beneficiaries.

However, prudent estate planning addresses far more than just keeping assets out of the probate process.  Minimizing income taxes and protecting assets from creditors is frequently a key objective of one’s planning.  Retirement assets left to an individual beneficiary may be taken away from them by current or future creditors.  For example, if the account participant dies while the participant’s son or daughter is in the midst of a divorce, then that child’s inherited portion of the account may very well pass to the soon-to-be ex-spouse.  Clearly the deceased Participant may not have wanted that outcome!  Similarly, should the surviving spouse remarry, a retirement plan left outright to the surviving spouse may ultimately pass to the surviving spouse’s new spouse.

The bottom line is that the beneficiary designation for retirement plan assets should be coordinated with the rest of the Participant’s estate plan. There are usually much better ways to deal with retirement plans than a simple outright designation to the surviving spouse with the children named as contingent beneficiaries.

Can a trust be named as a beneficiary of the plan?

Absolutely, although that must be done carefully.  The trust itself needs to be drafted in a particular way in order to achieve the desired results.  For example, when a retirement plan Participant dies, the IRS will determine whether there was or was not a “designated beneficiary” for the account.  The term “designated beneficiary” does not simply mean was a beneficiary designation form filled out and submitted to the company administering the plan.  Rather, from the IRS’s perspective there must be a living, breathing human being with a finite life expectancy specified to inherit the plan assets. A trust is not itself a living, breathing person.  However, if properly drafted, the IRS will “look through” the trust to the individual beneficiaries of the trust. Unless specifically drafted to create qualified designated beneficiaries, most trusts will fail to comply with these complex rules and restrictions. 

The specifics of those rules and restrictions are beyond the scope of this article. We are happy to talk to you in greater detail about those rules and the best strategy for dealing with your retirement accounts in your particular situation. 

Categories: Blog, Estate Planning

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