Leaving Retirement Plans to Heirs
by Chris Hardman | Hellam Varon
Retirement plan assets, whether held in Individual Retirement Accounts (IRAs) or in employer sponsored plans, like 401(k)s, often make up a substantial portion of a taxpayer’s wealth, but administering them after death is a process fraught with potential pitfalls. The rules surrounding retirement accounts are extremely complex, so making even a minor misstep in handling these assets may have huge consequences. Following are some of the areas where these mistakes frequently occur.
Beneficiary Designations
One key feature of retirement accounts is the right to designate a beneficiary who will inherit the account when you die. This seemingly small decision can have far-reaching consequences, including how long the tax-deferral benefits of the retirement account will last for your heirs.
Assets passing by beneficiary designation are not subject to probate, and are therefore not subject to the provisions of your Will (or Revocable Trust), so it is vital to coordinate your retirement plan beneficiaries with your broader estate plan. For example, a Will may create trusts to manage assets passing to your young children, but children named as beneficiaries of your IRA will receive those assets with no controls.
If no beneficiary is named, your estate usually inherits the plan by default. From an asset-protection standpoint, this subjects your retirement plan to the creditors of your estate. From a tax-planning point of view, it will substantially accelerate the income taxation of the retirement assets, since all assets must generally be withdrawn from the account within five years after you die.
Beneficiary designations should be reviewed regularly, and updated to reflect your current circumstances, because they are binding on the plan administrator and cannot be changed once you die. For example, consider a man who names his spouse as the beneficiary of his retirement plan, later gets divorced and remarries, but dies without ever changing the beneficiary designation. Much to the shock of the new spouse, his retirement account still passes to his first spouse.
Required Minimum Distributions
Plan participants are generally required to take minimum distributions (RMDs) from their plan each year once they reach age 70½. RMDs are computed from the fair market value of the account at the end of the prior year and a life-expectancy factor published by the IRS. Failure to withdraw the RMD can result in tax penalties equal to 50% of the required distribution.
After age 70½, a final RMD is required for the year of the participant’s death. Distributions taken by the decedent before death count toward the RMD, but any shortfall must be withdrawn by the beneficiary. Especially for people who die later in the year, it can be easy for this important step to be forgotten.
Beneficiaries are required to take RMDs beginning in the year following the year the decedent dies. The labyrinth of rules governing computation of beneficiary RMDs may require the services of a professional tax advisor; especially where there are multiple beneficiaries or a trust is the designated beneficiary.
Post-death Account Administration
Retirement assets passing to a decedent’s spouse can be rolled into the spouse’s own IRA, affording the surviving spouse greater flexibility than any other beneficiary. Any other beneficiary can roll over the account into an “inherited IRA,” but it can never be combined with any other IRAs. Checking the wrong box on the new account form for the beneficiary can mean the surviving spouse loses much of this flexibility.
It’s also important to note that only direct rollovers from retirement plans to inherited IRAs are valid. Once funds have been distributed to a beneficiary, there is no way to put them back into a retirement account, and the entire amount will be taxed to the recipient as ordinary income in the year it is received.
The IRS approved rollovers from a single retirement plan into multiple IRAs. For plans holding both pre-tax and after-tax contributions, this allows after-tax contributions to be converted to a Roth IRA with no tax consequences and pre-tax contributions to be directed to a traditional IRA.
While the rules that govern passing your retirement assets to heirs are complex, and may be difficult to navigate, many of the worst pitfalls can be avoided by simple actions once you are aware of them. Coordination between retirement plan provisions and your overall estate plan is vital to ensure your wishes are met.
This article is intended to provide general information on this complex topic, therefore many details are necessarily omitted. Always consult with professional advisors of your choosing who are familiar with all of the facts and circumstances of your situation before taking action on any of the ideas presented here.
Chris Hardman
Chris is passionate about helping families use their wealth to create lasting, positive legacies that provide security for future generations and positively impact their communities. He has strong technical expertise with Federal and multi-state tax compliance for individuals, trust & estates, and he is well-versed in estate planning and philanthropy.
