Retirement Plans and Estate Planning
At first glance, the concept of Individual Retirement Accounts (IRA’s), 401(k)’s and other retirement plans seems simple enough: A structured way to save for your golden years while deferring taxes on your growing nest egg. Unfortunately, that simple idea becomes one of the most complex areas of estate planning once IRS rules are applied.
Maximizing the Value of Your Retirement Assets
To ensure you are protected, an estate planning attorney must consider tax reduction techniques as they apply to your individual situation, and interpret complicated income tax rules and IRS regulations. Fortunately, our estate planning attorneys immerse themselves daily in the questions and concerns that IRA investors face in planning their estates.
The key questions with respect to management of Retirement Assets are when will they be taxed and at what rate. Ordinarily, income transferred to a standard retirement account are not subject to taxation in the year they are earned. Thus, we are deferring taxes until a later date. Even better, after the assets are inside the Retirement Account, they are not subject to taxation as long as they remain inside the account. Both income taxes and capital gains taxes are avoided altogether.
Does this sound too good to be true? It may be. That’s because all the assets in the Retirement Account are subject to ordinary income tax rates when they are distributed from the retirement account. This raises the questions:
- Who pays the taxes?
- At what tax rate? and
- When must the distributions be made (and therefore the taxes paid)?
These are among the main questions we explore when advising clients about their Retirement Assets.
Thinking about Tax Rates
After your death, funds in your retirement account – if directed to your spouse – will in most cases be rolled over at his or her choice into the spouse’s own retirement account. They will then be subject to distribution under the required minimum distributions rules applicable to a person’s own retirement account. This will be a favorable outcome in many cases because of the extended tax deferral.
Should anyone other than a spouse be named as beneficiary, they will not be able to do an account rollover. Unless they meet a short list of exceptions, they will have no required minimum distribution. Instead, they are required to distribute the contents of the retirement account to themselves within ten years of your death. They may do so at any time or times during that ten-year period, with no fixed schedule. If their goal is tax deferral, they might wait, continuing to deferring the capital gains taxes and income taxes on the investments until sometime late in the ten year period. On the other hand, if the account has a substantial value, waiting could mean a comparatively large amount is coming out at one time in the future – which might move them into a higher income tax bracket.
At some point, it is worthwhile to understand the relative value for your beneficiary of tax deferral versus management of income tax rate. Note also that “gains” on investments within the retirement account are exempt. But these amounts, which might have been taxed at the lower capital gains rate were they outside of the trust, will be taxed as ordinary income at a higher rate when distributed from the account. The point here is that avoiding capital gains one year and paying ordinary income the next (because it is year ten for an inherited IRA, for example), may be a bad deal.
There are other, even more advanced considerations where you have large retirement accounts. Should you convert a standard account to a Roth? Is there any chance a better tax outcome would arise if you took distributions during your lifetime? Should you make lifetime or testamentary charitable gifts from your retirement accounts? How can you use a Charitable Trust with your retirement accounts?
5 Steps to Begin Retirement Account Planning
As you begin to plan for your IRA, 401k, 403b or other Retirement Assets, organize your planning by determining each of the following:
- Survey your assets. Define all of your retirement accounts, determine their combined value, and consider their value compared to your non-retirement account assets. If you have Roth Accounts, separately account for them.
- Review your beneficiaries. Determine all of the people or organizations that will be receiving any gifts or shares of financial interests as a result of your death.
- Consider whether any of your beneficiaries are your minor children, disabled persons, or charitable entities. If you have charitable gifts as part of your estate plan, it is highly likely that they should be fulfilled as gifts from your standard (but not Roth) retirement accounts. Making the charitable gifts from these tax burdened assets will mean a larger share for your other beneficiaries from the rest of your estate. Further, under the present rules, certain disabled beneficiaries and your minor children will be able to defer distributions from Retirement Accounts after your death longer than will your other beneficiaries. This tax deferral can result in a significant overall tax savings.
- Give some thought to the tax rates of your beneficiaries. Some of your beneficiaries make more money than others and thus are in a higher income tax bracket. Where these differences are large, it may make sense for you to make beneficiary designations that account for these differences.
- Define your goals. Contact Clarity Legal Group® and make an appointment to include thoughtful planning for Retirement Account assets as part of your estate plan.
