For years, the government and financial experts have encouraged individuals to save more money for retirement. One of the best ways to save is to use tax beneficial accounts, including 401k, 403(b) or traditional IRAs. These accounts allow assets to grow tax deferred until the funds are withdrawn, which is not required until an individual reaches age 70 and a half. As a result, many people will die with significant assets in these tax protected accounts, which can pose challenges for proper estate planning. However, retirement asset trusts can provide a solution.
For purposes of estate planning, retirement accounts create a series of unique issues that are not present with other assets. Retirement accounts are generally not passed by a will, but instead are controlled by beneficiary designations. That is one reason why proper estate planning requires a comprehensive review of assets and accounts to ensure that significant assets held in a retirement account are inherited by the intended beneficiary.
Generally, beneficiaries of an estate are not taxed on inherited assets. (Neither the United States nor New York impose an “inheritance tax,” although some states, including New Jersey, do.) However, since funds held in tax advantaged retirement accounts (excluding Roth IRAs or Roth 401(k)s, which are not addressed in this article) were never taxed as income, withdrawals by beneficiaries are taxable income.
A primary planning goal with a retirement account is to maximize tax deferral. The longer assets are permitted to remain in the account, the longer they can continue to grow tax deferred.
A spouse who inherits a retirement account can roll it over into his or her own IRA, subject to the same withdrawal rules as any other retirement assets held by the spouse. However, if someone other than the spouse is the beneficiary, the withdrawal rules depend on whether the deceased started taking required minimum distributions (RMDs) prior to death.
IRS regulations provide that if the deceased did not start taking RMDs during his/her life, then the assets in the account must be withdrawn over the lifetime of the beneficiary. However, if no beneficiary was designated, or if the beneficiary is not qualified as a designated beneficiary, then the entire balance must be withdrawn within five years.
If the deceased began taking RMDs during his/her life, the funds must be withdrawn over the longer of the beneficiary’s or deceased’s life expectancy. If there is no qualified designated beneficiary, then the assets must be withdrawn over the deceased’s life expectancy (based on their age at death).
Planning challenges arise where a party does not want to leave significant assets to a beneficiary outright (whether because of age, creditor issues, disability, or other reasons). While retirement account holders can name a trust as a beneficiary, the trust must be carefully drafted in order to be a “designated beneficiary,” as the term is used by the IRS, to retain the tax benefit and avoid early withdrawal requirements.
Leaving retirement assets to a trust can help to maximize the tax deferral, while also protecting beneficiaries who may not be equipped to inherit assets out right. In order to leave retirement assets to a trust, the trust must qualify as a “designated beneficiary.” The trust must be valid under state law, be irrevocable (or become irrevocable on the death of the account holder) and have clearly defined beneficiaries. It can either be established during the decedent’s life, or as a testamentary trust established by will. The decedent can establish separate “sub-trusts,” with each sub-trust naming one primary beneficiary. Each sub-trust is then identified on the account as a beneficiary of a share of the retirement account.
Retirement asset trusts can be drafted in one of two forms. The first is a “conduit trust,” in which the trust does not accumulate assets, but instead provides for the required minimum distribution to be distributed from the trust to the beneficiary each year. This can be used in conjunction with a custodial Uniform Transfer to Minors Act account, to prevent a minor beneficiary from having unrestricted access to the funds. Because no funds are accumulated in the trust, the trust has fewer restrictions on who can be named as a remainder beneficiary. For example, if a decedent sets up a conduit trust which names his child as a primary beneficiary, but the child dies, it goes to an uncle as a residuary beneficiary. In a conduit trust, the IRS would use the child’s life as expectancy to calculate the RMD that had to be withdrawn every year from the account.
A trust can also be drafted as an “accumulation trust,” which allows the trustee to accumulate funds to be distributed to the beneficiary at a later date. These trusts require precision, specifically in designating remainder or alternate beneficiaries.
If an accumulation trust is not drafted properly, there is a risk that the trust will not qualify and, as a result, the assets would have to be withdrawn within five years. Alternatively, using the example above, the IRS could use the shorter life expectancy of the uncle instead of the child. Therefore, withdrawals would have to be made sooner.
Retirement asset trusts are a valuable estate planning tool that could result in decades of continued tax deferred asset growth. However, they require the detailed attention of an estate planning attorney, both in drafting the trust and confirming the beneficiary designations are correct.
If you have significant retirement accounts, contact us to discuss whether a retirement asset trust is right for you.
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This post does not constitute legal advice or establish an attorney-client relationship.