Thursday, July 18, 2019

Retirement Assets: The Neglected Stepchild in Estate Planning

“What do you want your monetary legacy to be?”

In reply, most people say they want to help their children, grandchildren, or other heirs. They want their wealth to be enjoyed or spent on education. Many people also express a desire to benefit a favorite charity or house of worship.

The most colorful response I’ve heard is, “We want to die broke. When the last of us is on our deathbed, we want to be down to our last few pennies.” Of course, that is easier to say than to do, as few of us know the day we will die.

Even if dying broke is your goal, you are likely to outlive at least some of your assets. I’d like to focus on one asset type that gets treated as a neglected stepchild – retirement assets.

Most people know that real estate, investment accounts, cash, insurance proceeds, vehicles, collectibles, and household items will become part of their estates, and often make specific plans to distribute those assets in their wills or trusts. But few of us think carefully about our retirement accounts, such as traditional IRAs, Roth IRAs, 401(k) accounts, or 403(b) accounts. Even though we often fund those accounts as fully as we can while employed, we rarely think concretely about their becoming part of our estates.

But the amount left in other retirement accounts, including “defined contribution” accounts such as 401(k)s, can be significant. So, when it comes to thorough estate planning, it is essential to account for the distribution of your retirement account assets and make sure that the distribution aligns with your estate plan as set out in your will or revocable trust.

Giving your retirement assets the attention they deserve when planning your estate

Here are five general considerations – most of which focus on naming the account beneficiary carefully. As always, we urge you to consult your attorney, tax advisor, or HL/Baird financial adviser for help:

1. Retirement accounts pass pursuant to your beneficiary designation

It is difficult to overemphasize the fact that, at your death, retirement account assets will go to the beneficiary (or beneficiaries) you designate for each retirement account – independent of the terms of your will or trust. Consider how the distribution of your retirement account coordinates with your overall estate plan to avoid potential unplanned outcomes.

For example, let’s say you revised your will or revocable trust terms to leave everything to your child, Alex, in a “spendthrift” trust because Alex has proven to be bad with money as a young adult. But you never update the beneficiary designation of your $500,000 IRA (your most valuable asset) from “Alex” to “Alex’s Trust” before you die. Result? When you die, Alex will get direct, immediate access to $500,000 in cash and can spend it at will, prudently or otherwise. You’ve just frustrated one of the main goals of your estate plan..

2. Who is the primary beneficiary?

Answering this question largely depends on the type of retirement asset you have: is it a taxable (traditional IRA or 401(k)) or non-taxable (Roth IRA or Roth 401(k)) retirement account? Baby Boomers typically have traditional retirement accounts, so most of the considerations below are for traditional accounts. Roth accounts are treated separately.

Spouses: Most married people want to ensure their spouse is provided for after they are gone. Naming a spouse as the primary beneficiary outright (as opposed to in trust, discussed later in #4) is one way to support this goal. It is also typically the most advantageous from an income tax perspective. Spouses get special treatment under our tax laws: Surviving spouses can elect to be treated as the owner of an IRA or can roll the IRA over into their own name and take required minimum distributions (RMDs) over their own life. At death, unless there is a specific reason to leave assets in trust, the surviving spouse can name children as beneficiaries (see below).

Note that some states (and ERISA for 401(k)s and 403(b)s) require retirement assets to pass to a surviving spouse or require spousal approval to name a non-spouse as beneficiary of any retirement assets.

Individuals other than spouses: A non-spousal beneficiary has a few options for dealing with the inherited account (options depend on the IRA owner’s age at death):

  • take the money in a lump sum;
  • take the money within five years; or 
  • keep the money in an “inherited IRA.”

The latter option will require the beneficiary to take required minimum distributions. If the beneficiary is younger than the IRA owner was at death, those RMDs can be based on the life expectancy of the beneficiary; this is often referred to as “stretching out RMDs.” To stretch out RMDs, the beneficiary must be a “designated beneficiary,” which is usually not difficult where an individual is named.

Also, when naming individuals as beneficiaries, consult the IRA account terms so that you have a clear sense of what happens if that individual dies before you and to ensure the above options aren’t further limited by the terms of the account agreement.

Charitable organizations: If you want to leave money to a charitable organization at your death, the easiest, most tax-efficient way to do so is by naming the charity as a beneficiary of taxable retirement accounts. Unlike individuals, qualified charities won’t pay income taxes on the withdrawals made from a retirement account, and anything left to charity at death is excluded from estate tax.

It is also easier to manage how much and which charities receive the benefits this way. To make changes, you simply execute a new beneficiary designation with your account provider (like your Hilliard Lyons/Baird financial advisor) rather than having to formally amend your will or trust terms with your attorney. And this isn’t an “all or nothing” option – you can specify that your charity should receive a certain amount (such as a percentage of the account or a specific sum) before passing the rest to one or more other beneficiaries.

Roth accounts: Roth accounts are a different beast. Though non-spouses must still take RMDs, there is usually no tax when money is withdrawn from a Roth account, and Roth accounts grow tax-free. So leaving a Roth account to a child (or even a grandchild) can be particularly advantageous if the beneficiary can be trusted to keep it in an inherited IRA.

3. Should you name a contingent beneficiary?

If you name an individual (rather than a charity or trust) as the primary beneficiary, consider having a backup beneficiary in case the primary beneficiary dies before you do.

If you name a charity, consider what might happen if the charity becomes unqualified (loses tax-exempt status for federal income tax purposes) or ceases to exist. Do you care if it still goes to that charity? Would you prefer the money go to a similar charity instead? Would you rather the money go to one of your other charities? Or would you rather the gift lapse and have the amount pass to your other individual beneficiaries?

4. Should you bequeath your IRA in trust?

In thinking about how you want to leave assets to your primary or contingent beneficiaries, you may want to start with your current estate plan as governed by your will or trust terms (or, if you are planning on updates to those plans, what those terms will look like).

Maybe you created a marital trust because you wanted to provide for your surviving spouse but you wanted to make sure anything left over passed to your children from a previous marriage rather than your stepchildren. Maybe you left inheritances to your children in trust for tax reasons or to protect them from creditors. Did you leave assets for a beneficiary in trust for life with a corporate trustee providing oversight because you don’t trust the beneficiary to manage their finances? In light of these considerations, would it be best to name a trust as beneficiary of your IRA rather than the beneficiary outright? Consider, too, the size of your retirement account(s): Accounts with smaller values might more appropriately be left outright or, if a significant portion of your wealth is already set to pass to a lifetime trust for a beneficiary, perhaps the value of the retirement account would be a nice sum to leave outright for them so they have more control?

If trusts aren’t part of your estate plan, consider whether certain heirs can handle inheriting an IRA outright or whether the benefits of a trust might be more suited to their situation. Inherited IRAs held in trust can provide many benefits and, where an experienced or corporate trustee is involved, you can rest assured that the complex rules governing inherited IRAs to help maximize tax savings are followed.

If you think your heirs might benefit from a trust, you can name a trust for a child (or another individual) as a beneficiary rather than leaving it to them outright. Basically, the assets would pass according to the beneficiary designation into the trust, and then the trust’s terms would spell out how the assets can be distributed to the child. But if you intend to name a trust as a beneficiary, trusts should contain specific language anticipating the flow of retirement assets to avoid excessive income taxation. If this is of interest to you, tell your attorney so that the appropriate trust language is included.

5. Rinse and repeat

Review your retirement accounts in context with your overall estate plan periodically, whenever tax laws change (see sidebar below), or as major life events occur (such as retirement, divorce, remarriage, death of a spouse).

You’ve worked hard. You prudently put away money in your retirement plans. Give those plans the attention they deserve when planning or updating your estate. Doing so can optimize the tax consequences of your bequests and help to establish the monetary legacy you intend.


Caution: The SECURE Act could change how you treat retirement assets

Note that, in May 2019, the U.S. House of Representatives passed legislation that, if enacted, will change some rules for retirement accounts. The SECURE Act (the “Setting Every Community Up for Retirement Enhancement Bill of 2019”) will make it easier to save for retirement.

In its current form, the SECURE Act has several provisions that might affect how you plan to distribute retirement assets after your death:

  • the maximum age for making IRA contributions will be repealed (so IRAs could be even more valuable when passing to heirs);
  • the age for starting RMDs will increase from 70-1/2 to 72;
  • the “stretch-out RMD rule” will limit the stretch to ten years.

So watch for tax law changes and work with your estate planning attorney or other financial professional to update accordingly.

Hilliard Lyons Trust Company does not provide tax or legal advice. Clients should consult their attorney and accountant regarding their individual situation.