Don’t Let the IRS Take 35% of Your 401(k)

Pension plans are quickly disappearing in both the public and private sectors.   As a result, traditional Individual Retirement Accounts (IRAs) and defined contribution plans under Section 401(k) of the Internal Revenue Code (401ks) will most likely become the most significant assets in many estate plans. These assets are typically “qualified,” meaning that the money is deposited into these retirement accounts on a pre-tax basis, with the income taxes being collected upon withdrawal.

By now, most people know not to place qualified retirement assets into revocable living trusts. However, simply naming a trust as the beneficiary to an IRA or 401(k) plan could present its own hazards. For example, a lay trustee, who fails to consult with an attorney or other tax professional, could conceivably liquidate the entire retirement account in order to place all of the assets into the trust at one time, believing that this was required by the beneficiary designation. In this scenario, the placement of the retirement assets into the trust would be a “lump sum distribution” to the trust, meaning that the full value of the assets transferred would be taxed all at once – as ordinary income to the trust at the trust tax rate.

For example, for the tax year ending December 31, 2012, trust income over $11,650 will be taxed at a rate of 35%. So if a $500,000 IRA is liquidated and placed into a trust, the trust will be deemed to have “earned” $500,000 in ordinary income for that one year, and taxed accordingly. The best solution is to spread the distributions over time, so that the distributions are smaller, taxed at a lower rate, and more easily offset by expenses.

A person may begin receiving distributions from his retirement account at age 59 ½,” but he must begin receiving distributions when he reaches the Required Beginning Date (RBD), which is currently by “April 1st of the year following the year in which one reaches age 70 ½,” according to the Treasury Regulations. As such, an account owner may not avoid paying income taxes by simply refusing to take distributions from his retirement account.

The Internal Revenue Code also limits the amount of “spreading” that an account owner may do to reduce his tax burden or to leave more for his children, by establishing a minimum amount that must be distributed from his retirement account on a yearly basis. This is known as, “Required Minimum Distributions” (RMD), and they are calculated according to a formula based on the account owner’s life expectancy. An experienced estate planning attorney can help ensure that this spreading of distributions over time continues after the death of the account owner, and can even reduce the income taxes further, by having the distributions spread out over the life expectancy of the beneficiary.

Having an individual named as the designated beneficiary (as opposed to “the trust”) for each retirement account is the first step toward ensuring that the distributions will be paid out over the beneficiary’s life expectancy. A surviving spouse, who is named as a beneficiary, may simply rollover the retirement account into his or her own traditional IRA. However, beneficiary designations become more complicated upon the second to die, if minor children are involved.

The table below shows the period for distribution of retirement assets if the account owner dies BEFORE the RBD.

The above table makes it clear that failing to specifically designate a beneficiary for retirement assets can reduce the period for distribution from the beneficiary’s life expectancy to five years, thereby substantially increasing the beneficiary’s income tax burden. The next table shows the period for minimum distributions if the account owner dies AFTER the RBD.

The above table demonstrates that once the account owner has reached his RBD, having a beneficiary specifically designated could mean the difference between an account owner’s ten-year life expectancy and a beneficiary’s 40-year life expectancy. The tax consequences or savings could be substantial.

While tax savings is important, it is simply impractical to designate a minor child as a beneficiary to a retirement account. Having a trust in place would be a necessity. Done properly, a trust can be drafted so as to provide trustee oversight, yet still be deemed as having individually named beneficiaries. These trusts are known as “conduit trusts” or “see through trusts.” These trusts will only work, however, if the following rules are observed:

The trust must have a clearly identifiable beneficiary. A trust that does not have a clearly identifiable individual beneficiary or one that includes any undetermined beneficiaries, such as “issue,” “heirs,” “children” or provisions for a charity, could result in the retirement account being deemed as having no designated beneficiary at all, which would in turn result in the acceleration of income tax due. To avoid this, the beneficiary designation language must be drafted carefully, in both the trust and the plan documents. For a trust to qualify as having a designated beneficiary, the following four elements must be met at the time the Required Minimum Distributions are determined:

1. The trust is valid under state law;
2. The trust is irrevocable;
3. The trust beneficiaries and their ages are identifiable; and
4. Trust documentation is provided to the plan administrator by October 31st of the year following the participant’s death.

If all four requirements are met, then each beneficiary’s minimum required distribution will be calculated using the oldest trust beneficiary’s life expectancy.

Use of a conduit trust to receive an account owner’s retirement assets should be determined on a case-by-case basis, depending upon the account owner’s goals, desires and financial situation.   Owners of qualified retirement assets should consult with an experienced estate planning attorney as the tax laws, account owner’s goals and the value of retirement assets continue to change.