Today, it is more and more common for an individual's retirement benefits to be one of their largest assets. The increased popularity of employer-sponsored qualified plans and individual retirement accounts means some individuals will be allowed to save more money than they expect they'll need for retirement. Because these accounts may still hold a substantial amount at the grantor's death, the treatment of the remaining assets must take into account the individual's objectives and the rules related to retirement benefits.
Planning for retirement assets requires that your clients consider both federal estate and income taxes. Currently, the federal estate tax allows individuals to pass on a certain amount without incurring an estate tax. In 2007, this amount is $2 million. But by taking the appropriate steps, many individuals can avoid most or even all estate taxes. However, all distributions coming from retirement assets, with few exceptions, are subject to income taxes. As a result, even for individuals who can avoid estate taxes, it may be beneficial to plan ahead. This is important because it ensures that assets are distributed the way the client wishes and also because it ensures the potential income tax liabilities of those distributions will be considered and discussed.
In order to reduce income tax liabilities, the retirement assets' owner should consider ways to reduce the minimum required distributions (MRDs) that beneficiaries would normally receive. All plans require both the retirement account owner and the beneficiary to eventually take MRDs from the account. An account owner must begin taking MRDs no later than April 1 of the year following the year when they reach age 701/2. MRDs for an account owner are calculated by dividing the prior year's account balance by a life expectancy factor published by the IRS that is based on the owner's age.
MRD rules also apply to beneficiaries who inherit retirement accounts, but the rules differ in their application from the account owner. One factor that has the greatest impact on how these rules apply is whether there is a designated beneficiary for the account.
The term "designated beneficiary" has a special meaning under the rules relating to retirement accounts. Only individuals, for example, can be designated beneficiaries. The owner's estate cannot be a designated beneficiary, even if individuals are the ultimate beneficiaries of this estate. If the owner has a trust, the trust beneficiaries may be treated as designated beneficiaries if the owner has complied with a number of rules. There may be more than one designated beneficiary so long as the beneficiaries are all individuals.
The designated beneficiary has a number of distribution options that can help delay some income taxes. First, if the beneficiary is a spouse, they can roll the retirement account into an IRA. This allows the spouse to use their own life expectancy to calculate MRDs and to possibly delay their commencement date if they are not yet 701/2. If the designated beneficiary is not a spouse, the beneficiary will still be able to stretch out the distribution period over their life expectancy.
If there is no designated beneficiary, all assets must be withdrawn in five years. If the account is substantial, a five-year payout will incur substantial tax liabilities at potentially the highest income tax bracket. In contrast, if the account can be paid out over a 30-year life expectancy, the tax consequences will be much more incremental.
A retirement account owner should complete and regularly update their beneficiary designation form to ensure the account will be distributed according to their wishes. The beneficiary designation form, not the account owner's will, governs how the retirement account is distributed upon the account owner's death.
Through careful planning, retirement account owners may be able to reduce the income tax consequences for their beneficiaries and ensure that their assets are distributed as intended. These issues are complicated and should be thoroughly examined in light of the ultimate goals of the retirement account owner. Even if planning is favorable from an income tax perspective, it may not meet the account owner's objectives for a number of other reasons.
Ann Liefer is an attorney with the Michigan-based law firm Warner Norcross & Judd LLP, and her practice focuses on trusts and estate law. She can be reached at aliefer@wnj.com or at 616-752-2188.
