Many Americans have a retirement account such as a 401(k), 403(b) or IRA during their lifetime to supplement income in retirement. As with all traditional pre-tax accounts, most know that withdrawals will be taxable as income and mandatory distributions are required starting at age 70.5. We do get a lot of questions on what happens to those accounts when someone passes away and what the rules are. If you don’t have any beneficiaries listed on your retirement accounts, the accounts will be included in the probate process of your estate. If you have a will, then your instructions will help guide the court to distribute your assets. If you don’t have a will, then the court will rely on your state’s intestacy statutes to decide who gets everything. These are not the most ideal or efficient methods to leave retirement assets to loved ones.
The easiest way to improve your estate plan is simply designating a beneficiary on your account. If your beneficiary is a spouse, they will be able to either absorb your account into their own IRA or into an inherited IRA account based on their individual needs. If your spouse chooses the latter option or a non-spouse beneficiary inherits the assets, then there are some special rules for distributions from an inherited IRA.
The first option is the “Five-year method”-The entire account must be withdrawn by the end of the fifth year following the death of the deceased owner. Nothing needs to be withdrawn over the first four years, but by the end of fifth year, the account must have no balance which could lead to some serious tax issues of a large IRA.
The second option is the “Life expectancy method” (also called a stretch provision or stretch IRA). This requires the beneficiary to start taking the required minimum amount by December 31st of the year after the IRA owner’s death and every year after. It allows them to continue to accumulate the assets minus the minimum required withdrawal and spread out the taxability over their lifetime.
Many IRA owners we’ve met would prefer that their heirs take the minimum amount and continue to grow those assets for their own retirement income needs. However, preference and reality can be two different things. Through your estate planning you may have engaged a qualified attorney to create a trust. Trusts can be implemented for a variety of reasons, and it is important to fund the trust with appropriate assets that should pass by way of trust provisions. The one thing you can’t do is put your IRA funds in it while you are still alive without receiving a big tax bill from the IRS. You can, however, have your trust as the IRA beneficiary and still have your heirs benefit from the stretch provision I mentioned above if four key items are covered:
1. The trust must be valid under state law.
2. The trust and list of beneficiaries must be provided to the custodian by October 31st of the year following the IRA owner’s death.
3. The trust must become irrevocable upon the death of the owner. (This one is important in case you have a trust where both spouses are beneficiaries and the trust could still be changed or amended after the death of one spouse.)
4. All the beneficiaries must be identifiable as eligible designated beneficiaries and be an individual or class group (all our children or grandchildren for example). The beneficiary cannot be an entity such as a charity. (This is probably the one that can fail the rules since non-person bequest no matter how small the amount can make the trust ineligible for the look through provision.)
The idea of having the trust as your beneficiary is that you can stipulate all the provisions of your trust, while still giving your heirs the ability to use the IRA as a legacy and minimize the tax impact to them. You might think that these requirements sound simple enough, but just because you can doesn’t mean you always should. An experienced estate planning attorney will make sure that your current will, or trust reflects what is best for you and your family. We would like to know what estate planning you have done and review your documents to make sure they meet your wishes. If they don’t, we’ll refer you back to your attorney with some notes to make necessary changes.
Image Credit: Terry Johnston