How are Retirement Plans Handled in an Estate Plan?

Retirement plans, including IRAs, 401Ks, 403Bs and 457As, are not controlled by common estate planning documents such as wills and revocable living trusts. They transfer to heirs by a beneficiary designation. So whomever you name as beneficiary, when you initially signed that plans document, is the person that will receive the value in the account when you pass away.

This lack of control sometimes can be problematic, especially when an individual retirement saver has designated a beneficiary and has forgotten to keep those designations up to date. The plan documents will control where the money goes and your last will and testament will have no effect because beneficiary designations avoid probate. Your retirement plans will also not be controlled by a revocable living trust because the plans are not trust property; they are individual property.

Is the Title of a Retirement Plan Going to be Transferred to a Trust Upon Someone’s Death?

No, what happens is that beneficiary is contacted by the custodian. For example, you have an IRA in a brokerage account. You pass away, and hopefully, you have designated beneficiary’s, for example your spouse as the primary beneficiary. The broker or your financial advisor calls up your spouse and says, “You are the designated beneficiary of this retirement account there is $100,000 in it and you have a few options for distribution. What would you like to do? Would you like to pay the income tax obligation now, cash it out and do whatever you wish with the money, or do you wish to inherit this IRA and stretch out the tax obligation over your lifetime keep it as your own retirement fund?” Now there are different rules as to whether spouses inherit or children inherit, but that’s effectively what happens when a custodian handles the transfer to the designated beneficiary.

What Taxes are a Retirement Plan Subject to Upon Someone’s Death?

Retirement plans are subject to income tax. The purpose of retirement plans is to accumulate money on a tax-deferred basis, save now and pay tax later when you start to take distributions. When a person inherits, there are three choices that they really have. One of them is to liquidate the account and pay the income tax in the year of distribution. The amount of income tax is going to depend on the individual’s tax rate for the year. When including the individuals earned income from employment and the amount of the inherited retirement account a beneficiary could land on the tax tables leading to a substantial amount of income tax due, as much as 40%, significantly depleting the value of the inherited funds and reducing future growth. A beneficiary can also choose to take distributions out over five years but the account must be liquidated by the end of that period. Often that will put you in a lower tax bracket meaning a lower of a tax hit but still resulting in a removal of the funds from tax deferred investments. The third option, is called the Life Expectancy method or what is called a “stretch IRA.” You can inherit an IRA and then stretch out that tax obligation over your lifetime. This is by far the preferred option. The account will continue to enjoy tax deferred growth and will ultimately result is far more money going to your beneficiary’s.

It is critical that we have an identifiable person with a pulse and a birthday so we can take advantage of that tax deferral over another lifetime. This is up to the beneficiary to make this choice. Unfortunately, the vast majority just decide to cash it out. They either do not want to deal with the IRA, or they don’t understand the power of continued tax deferral, so they cash it out. The best choice by far is the stretch IRA. Many books have been written about how you can build a legacy of retirement for multiple generations by rolling over IRAs.

For example, a 35-year-old child inherits a $200,000 IRA and decides to keep it as their own. They’re going to inherit it and then stretch that obligation out. So the entire $200,000 is going to roll into an IRA account for them, an inherited IRA, but the child has to take a required minimum distribution (RMD) right away. An RMD is based on the IRS actuarial tables, which figure (about) an 85 year lifespan. So in the case of a 35-year-old child, the IRS estimates a remaining 50 years and will ask for RMDs based on that. In very broad generalizations, about 1/50th of the IRA has to come out that first year, on which taxes are paid, but the rest continues to roll, tax-deferred, as long as it stays in that account. This is hugely powerful when it comes to growth and potential money down the road when you really need it in retirement, versus using it now to add onto the house, buy a car and take a trip to Disneyland. It just makes much more sense to take advantage of the stretch.

For more information on Retirement Plans In Wisconsin, a free initial consultation is your next best step. Get the information and legal answers you are seeking by calling (608) 616-4985 today.