By Neil L. Kimball
Many clients believe that their Will or Trust will govern the distribution of all of their assets upon their death. If you read those documents, they typically sound all-encompassing. However, in reality, assets such as life insurance and retirement plans are contractual arrangements between the owner of the asset and the company administering the insurance policy or retirement plan. Part of that contractual arrangement is the designation of beneficiaries in the event of the death of the owner. For life insurance, the issues are not as critical because life insurance is income-tax free. Although life insurance is included in the owner's estate for determining whether or not any estate taxes are due at death, the beneficiary of life insurance will receive the proceeds free of income tax.
However, with respect to retirement plan assets, such as individual retirement accounts (excluding Roth IRA's), 403(b) and 401(k) plans, when individual beneficiaries receive these assets, they will eventually be subject to income tax. As a result, it is critical to consider the tax ramifications when determining who to name as the beneficiaries.undefined
- Leaving Retirement Plan to “Estate.” It is usually undesirable to leave the plan payable to the owner’s “estate.” By designating the estate as the beneficiary, the plan assets must pass through probate proceedings. Although probate proceedings are seldom disastrous, it is usually better to name specific beneficiaries such as spouse, children or perhaps a trust if necessary to avoid probate expenses.
- Spousal Roll-Over. As a general rule, if an owner is married, it is preferable to leave the retirement plan assets to the surviving spouse. This is because a surviving spouse can do a “spousal rollover” of the retirement plan into his or her own IRA and defer income tax until he or she attains age 70-1/2 (after which the spouse must take minimum required distributions from the plan and pay income tax at his or her then current income tax rate). One issue to consider when leaving the proceeds directly to a spouse is that the spouse may later name new beneficiaries to receive the proceeds upon the spouse’s later death. In a second marriage situation, this may not be optimal.
- Option to “Stretch” Retirement Plans. Who to name as a secondary beneficiary for a married owner or who to name as a primary beneficiary for a single owner can be more involved. If we take the example of a single person who has children, the decision may rest upon whether or not the children are minors or otherwise unable to manage assets well. If the single person’s children are adults and able to manage assets, it is usually preferable for the owner to name his or her children directly as the beneficiaries because the children may take their share of the retirement plan and pay tax on the plan over their life expectancy (or over the life expectancy of the oldest child). This can result in a substantial deferral of the income tax on the plan and the plan could actually grow over the child’s lifetime. This ability to “stretch” the retirement plan over the child’s lifetime can result in substantial income tax savings. Of course, just because the owner names his child as a beneficiary does not mean the child has to defer the income tax. The child will have the option of taking a lump sum and paying all of the income tax at once. In fact, statistics show that most children given this choice will take a lump sum and pay all of the tax upfront. Nevertheless, if the owner feels his children are able to manage the money and will make a wise decision, then naming the children directly as the beneficiary of the retirement plan is usually advisable. Each child will then at least have the option of deferring income tax over his or her life.
- Considerations With Younger Children. If the owner’s children are minors or otherwise unable to manage money effectively, then the owner may want to establish a revocable trust for the benefit of the children and name the trust as the beneficiary. In this manner, most often the taxes on the retirement plan have to be paid over five years after the owner’s death at the trust income tax rate (currently 35%). While it is slightly more deferral than a lump sum payout to a child directly, this option still gives up much of the deferral that could be available to a child if the retirement plan were stretched over the child’s lifetime. In essence, the owner has made the determination that it is preferable to have the net proceeds of the plan managed for the child’s benefit according to the terms of the trust than it is to possibly defer the income tax to the maximum extent but let the child decide. Another reason not to leave retirement plans directly to minor children is that a conservator will have to be appointed through the local probate court to manage the benefits until the children reach age 18. At age 18, the children will have unrestricted access to the funds and may choose to take a lump sum payment at that time and pay all of the tax on the plan assets. Often when owners have younger children, we suggest that the benefits be payable to a trust for the benefit of the children until such time as they attain an age and maturity that they can handle finances on their own. At that time, the owner can change their beneficiary designation form through their retirement plan administrator to leave the proceeds directly to the children to give them the option of deferring tax longer.
- Charitable Beneficiaries. If an owner desires to leave assets to charities at death, the retirement plan is one of the best assets to use because retirement plans consist of pre-tax money. If the owner leaves them to family members or other individuals, income tax will be paid on the proceeds. However, if the owner leaves a retirement plan asset to a charity, the charity receives the entire value of the account without having to pay income tax. So, rather than leaving other after-tax assets to charity, it is often tax-wise to leave retirement plan assets to charities. The other advantage of leaving retirement plan assets to charities is the fact that the owner can change the beneficiary designation from time-to-time to reflect the owner’s current charitable intentions. In other words, the owner does not need to revise a Will or Trust through an attorney if the owner decides to switch from one charity to another.
The one complicating factor is that if the owner has a relatively large retirement plan and does not wish to leave all of it to charity, the owner should divide the retirement plan into two parts, one part in an amount roughly equal to the amount the owner wishes to leave to charity and the other part to be left to family members or other individual beneficiaries. If the retirement plan is one large account and a portion of it is left to charity and the other portion of the same plan is left to individuals, then the individuals may not avail themselves of the income tax deferral advantages of stretching the retirement plan over their life expectancy.
For example, there is an individual retirement account of $200,000 and the owner wishes to leave $50,000 in equal shares to two charities, the owner could split off $50,000 out of one IRA and create a new IRA in that amount and name the two charities as equal beneficiaries. The balance in the initial individual retirement account could be left to the owner’s children in equal shares. Once the owner is past age 70-1/2, the owner will need to begin taking minimum required distributions out of the owner’s retirement plans. The owner can control the value in the two different individual retirement accounts by picking and choosing which IRA from which the owner will take his minimum required distribution.
There are many considerations involved in naming beneficiaries of a retirement plan and each client‘s situation and retirement plans can vary. Therefore, before naming beneficiaries on retirement plans, you should consult a competent advisor which usually should include your estate planning attorney and accountant.