Remember that first day of your new job? Sitting anxiously and nervously as that kind human resource manager patiently walked you through endless stacks of “on-boarding” paperwork. Remember the beneficiary designation form you filled out for the company’s 401(k) that day? Remember who you named as the beneficiary of your 401(k)? Probably not, and not many people do. However, the beneficiary, or lack thereof, named on your retirement account not only affects who will receive those assets, but how and when they are taxed. If not done properly, the distribution of one of your largest assets could pass contrary to your intent with unnecessary tax implications.
Retirement assets, such as individual retirement accounts (“IRAs”), 401(k)’s and other qualified plans contain pre-tax dollars. Money you put away in a specific type of savings vehicle which allows you to avoid paying tax on that money until such time as it is withdrawn in the future. These types of accounts allow you to name a beneficiary who will receive the balance of the assets in that account upon your death. Simple, right? Well, not really. Since these accounts contain pre-tax dollars, the IRS is anxiously waiting for the money to come out of the account so they can collect income tax. How and when the retirement assets are taxed depends on a number of factors. Complicating matters was the passage of the Setting Every Community Up for Retirement Enhancement Act (“SECURE Act”) on January 1 st of this year. Prior to the SECURE Act, beneficiaries of retirement assets (with certain exceptions) were able to continue deferring taxes and take required minimum distributions over their life expectancy. The SECURE Act, however, changed that. Again, with limited exceptions, non-spouse beneficiaries now must withdraw all assets within a ten (10) year period. With retirement assets beginning to make up the largest percentage of an individual’s wealth portfolio, proper planning for succession of retirement assets is critical.
- Putting Your Spouse First. You learn this rule the day you get married, but it also holds true for your retirement assets. When named as a beneficiary, spouses are afforded the unique ability to roll over those assets into their own IRA and treat them as their own. This maximizes tax deferral and provides the greatest amount of flexibility for planning. Keep in mind however, these assets will go outright to your spouse, so special circumstances, including blended families may require additional planning.
- Giving it to the Kids. Besides our spouse, our children are the next natural beneficiaries of our assets. While your estate plan may provide for a trust to hold their inheritance until a certain age, or restrict their access to the assets until specific conditions are met, a standard beneficiary designation will distribute those assets outright. This means that if you name your child as a beneficiary of your retirement account, they will receive those assets regardless of their age or life circumstances. Take Jeff’s story for example. Jeff was a widower with one son, Peter, who just turned eighteen. Jeff passed away unexpectedly with his largest asset being an IRA naming his son Peter, as the primary beneficiary. Since Peter was eighteen, the IRA paid out directly to Peter – free of restrictions. Can you guess what Peter did? He did what any young eighteen year old would do; he withdrew from college, cashed out the IRA and bought the fastest, most expensive car he could find. Not only did Peter unnecessarily accelerate the income tax on the entire amount of the IRA, his inheritance is now fully invested in a depreciating asset.Each family is unique, so careful planning and consideration should be given when naming children as a direct beneficiary of your retirement account.
- Maximize Your Retirement Assets with Charitable Intent. An often overlooked use of retirement assets is to carry out your charitable intent. If you intend for a portion of your estate to go to charities, consider naming those charities as direct beneficiaries of your retirement account. Distributions which go directly to charities are not taxed, therefore the charities receive one hundred percent of every dollar distributed. If you have both individual and charitable beneficiaries, consider setting up separate IRAs or coordinating your estate plan and assets in a way that directs the charities’ portion of your estate shall first come from your retirement accounts.
- Make Sure Your Estate Plan and Beneficiary Designations are Consistent. A common misconception is that your estate plan documents control distribution of all of your assets, including your retirement accounts. Unfortunately, this often leads to inconsistent distribution of assets between an individual’s estate plan and retirement accounts, as well as an acceleration of taxes. Remember that beneficiary designation form? Well, by operation of law, that document controls how your retirement account is distributed, not your Will or Trust. It is not uncommon to fill out your beneficiary designation form and never look at it again. The problem? At the time you signed it, you were single with no children so you named your parents as the beneficiaries. Now, ten years later, you are married with three kids and your estate plan leaves all of your assets to your wife and children. Since the beneficiary designation on your retirement account, not your estate plan, controls that asset, your parents stand to receive that account, not your wife and children. Another common mistake is to designate your “estate” as the beneficiary of your retirement account. Seems reasonable, right? Unfortunately, naming your “estate” as the beneficiary only makes the IRS happy. While the account will eventually get distributed in accordance with your will, it significantly accelerates the payment of income taxes. Instead of your spouse being able to continue tax deferral for their lifetime, or your children having the ten (10) year tax deferral period, your estate is subject to a mandatory five (5) year withdrawal period.
The same thought and planning that you have put into saving for retirement should be applied to the succession of those assets. Periodic review and updating of beneficiary designations is crucial to avoiding inconsistent distribution patterns, unintended omissions and unnecessary taxes. As Benjamin Franklin famously said, “By failing to prepare, you are preparing to fail.”