Estate Planning With Retirement Benefits

An increasing number of Americans are growing the bulk of their wealth through retirement accounts (such as IRAs and 401(k)s), especially as defined benefit pension plans have become increasingly rare. Few people are expecting to survive on Social Security exclusively.

With this investment comes to an important question – what will you do with the remainder of your savings, should you die before it is spent? We cannot take much with us into the grave. Bank accounts, investment accounts, assets, properties, and trusts are bequeathed upon death either per your instructions or state law.

Retirement benefits and accounts are some of the few assets that have the luxury of entirely skipping the probate process, provided you’ve named beneficiaries in your account or made it part of a trust built to make payments to your family on your behalf. Sometimes, it is a little more complicated than that. There are tax issues to consider, and who best to name as beneficiary.

Retirement Benefits and Estate Plans

An estate plan sounds extravagant, and most people picture the idea of a decedent’s estate to be terminology reserved for artists and the exceptionally wealthy. But estate plans can range from a simple will to a series of documents meant to preserve a loved one’s finances and dignity while suffering from a chronic health condition.

Whether you leave behind a modest sum or a large fortune, an estate plan matching your means in scope and intent is almost always a good idea because the alternative – dying intestate – means that the division of your assets and accounts is entirely out of your hands. Most estate plans aim to accomplish two things:

      1. To reduce or minimize the cost of distributing the estate contents.
      2. To ensure that properties and assets are appropriately allocated.

Retirement Accounts and the Federal Estate Tax

State estate tax exemptions and tax rates differ, with some states – like California – having no state estate taxes. The federal estate tax, on the other hand, is by far the highest potential cost on any person’s accrued assets and property and currently only affects estates with assets and property over a total of $11.58 million for individuals in 2020 (and double that for estates using a combined marital exemption).

However, this exemption is historically very high (it is three times the estate tax exemption we had in 2009, for example). It may lower in the coming decades, affecting a much greater number of Americans. Estate plans can help minimize the impact of estate taxes on your savings, often by:

      • Focusing on the implications of IRAs, 401(k)s, and life insurance policies on the total value of your estate.
      • Offering advanced techniques for preserving or transferring assets between generations reduced tax rates through specialized and advanced trusts.

Retirement Benefits, Distributions, and Estate Planning

Estate plans can also help you better control how your assets and accounts are distributed after your death. While retirement benefits and accounts are not subject to a will – and should not be, so long as you named your own primary and contingent beneficiaries – there are other ways of fine-tuning the bequeathment process. Usually, the retirement account itself determines how distributions occur after death. Beneficiaries typically gain access to the account, with the option of either:

      • Cashing out a lump sum.
      • Cashing out after a 5-year waiting period if the account holder died before a certain age.
      • Continuing to take out minimum required distributions until the IRA is spent.

Distributions are taxed at the beneficiary’s income tax rate depending on the kind of retirement account. Whether the account holder died before or after the beginning date of their required minimum distributions (RMDs), and whether the sole beneficiary is their surviving spouse.

However, if the account’s beneficiary is a trust – an estate planning instrument – rather than a human individual, the rules can change drastically. Retirement account trusts may be incredibly beneficial and can help some estates preserve the value of an account and better control its distribution to multiple beneficiaries, but maybe too complex or expensive to maintain for others, making it essential to consult an estate planning professional beforehand.

For example, naming a trust as beneficiary can help preserve the IRA’s value in the long-term by making annual distributions to the trust’s beneficiary, rather than giving them a lump sum they might not use wisely. A retirement account can also be used to finance a trust used to benefit a special needs child. Special trusts can also be set up to avoid having a retirement account’s total assets be folded into a surviving spouse’s estate for tax purposes.

Know Who Gets Taxed

Regardless of whether retirement benefits are distributed during retirement, in a lump sum after death, as an inherited IRA with required minimum distributions, or through a trust, the contents of a retirement account are typically taxed once they are distributed, as assets held in qualified plans, and IRAs both generate no tax liability.

The tax rate on retirement account distributions is the same as the account holder or beneficiary’s income tax rate. But a significant exception applies to Roth accounts. Roth IRAs or Roth accounts can be used to make tax-free withdrawals and distributions. Some important things to note are:

      • Roth contributions cap at $6,000 a year in 2020 for those under the age of 50 and $7,000 a year for account holders who are 50 or older. You may contribute less or nothing at all if your income reaches an absolute cap (annual 2021 revenue of $140,000 for individuals), based on your MAGI.
      • Roth contributions are also made on an after-tax basis, which is why these can be withdrawn tax-free.
      • Earnings remain taxable when removed unless they are “qualified distributions” (i.e., profits made after the account holder turns 59 ½, is disabled or dies, and more than five years have passed since the first contribution).
      • You can only contribute earned income to a Roth IRA.
      • You can contribute to a Roth IRA at any age, which used to be a unique feature until the SECURE Act allowed traditional IRAs.
      • While you can withdraw contributions tax-free at any time, there are penalties and tax costs on withdrawing earnings too early or late.

Accessing Funds Before Retirement

While there are penalties for early distributions, it should be noted that the CARES Act allows Americans to withdraw as much as $100,000 from a traditional or Roth IRA without paying the penalty if they have been affected by COVID-19. Otherwise, there are penalties for making withdrawals before the account has reached a certain age before 59 ½.

Conversely, once you reach age 70 ½, the account is expected to take the required minimum distributions to avoid penalization. Similarly, beneficiaries who do not cash out their inherited retirement benefits must make required minimum distributions after December 31 on the year that the account holder died.

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