A complete financial plan has many moving parts, many of which are handled by separate financial professionals. A financial advisor likely does not sell property and casualty insurance, but she’ll want to know and understand that a client’s home and property are protected. An advisor does not sell mortgages, but she’ll need to understand a client’s debts and liabilities in order to create a better plan. An advisor also does not create will, trusts, or other estate planning documents, but he or she needs to understand what the client’s plan looks like since so many of a client’s priorities can be gleaned from a look at their “end-game.”

But for financial advisors, it can be much larger than that. Not understanding a client’s estate plan can (and does) result in big losses . . . to relationships, to families, and to an advisor’s bottom line. Let’s look at three easy ways to lose clients by ignoring estate planning:

Loss #1:  Not funding the client’s revocable trust.

Money in the air.If a client already has an estate plan or has planning performed because of an advisor’s recommendation (a good recommendation, generally), the client may end up with a probate-avoidance tool called a revocable trust. A revocable trust more or less adds beneficiary designations to assets that would not ordinarily have them — real estate, cars, boats, furniture, personal property, etc. Because of this, the assets held by the trust avoid the probate process (and all of the probate-associated expenses, heartaches, and inefficiencies).

But this only works if the client’s assets are actually held in trust. Too often a client will have their revocable trust created, and then never actually add anything to it. This creates problems because if the assets aren’t held in the trust, then the assets are not controlled by the trust document and will likely have to go through the probate courts. Meanwhile, the client has paid for an estate plan which has become useless.

The attorney will do his or her best to give the client the proper tools to get these assets transferred. For example, the attorney will create and file the necessary real estate deeds and will draft assignments of closely-held business interests. But it’s the financial advisor who will be meeting with these clients regularly. By working with the client to make sure assets are titled correctly (including that beneficiary designations are accurate and valid), the advisor ensures that the plan works. When a client passes away, the advisor is the one often holding the bulk of the assets . . . if the advisor has involved himself in the estate plan, the family transition will more likely happen smoothly and without a hitch. This gives the advisor a chance to work with the family closely and, hopefully, gain their trust and confidence for another generation. For advisors who are less inclined to work with estate planning, a rough and frustrating legacy transfer can be a deal killer for retaining assets.

Loss #2: Not considering the effects of income taxation on estate planning.

We know and understand that estate taxes can be a problem when a client passes away. But what about income taxes?

When a client dies, their appreciated assets receive a step-up in cost basis. Briefly, this means that if that any stock, real estate, or other asset that would ordinarily get sold and have capital gains tax liability will instead transfer to the beneficiary with a new cost basis determined on the client’s date of death. The beneficiary can then sell these assets without incurring capital gains taxes. This is a really big deal for assets with substantial appreciation. Note that this only happened for transfers on death — if the client were to gift appreciated assets to a family member during the client’s life, the family member would take the client’s original basis and any sale could result in the realization of any capital gains tax liability.

What this means is that appreciated assets are a great thing to pass on to family members after death rather than during life. It also means that if a client is considering making charitable gifts, perhaps there are other assets that might make better sense to give. A great example is qualified money.

As you are aware, qualified IRA and 401K dollars are taxed as ordinary income when distributed to a beneficiary. This is also the case for beneficiaries of the next generation. If a client’s child has the choice between taking stepped-up, tax-free appreciated assets or assets that are taxed at the child’s effective income tax rate, you can guess which they would likely prefer. If there is one class of assets that are perfect for charitable donations, it is those assets that are taxed the highest — qualified money.

A client’s family member who realizes these savings is much more likely to want to work with the professionals who helped to make these savings a reality. Likewise, a huge, unnecessary tax hit will help to ensure that the client finds new professionals when creating their own family legacy.

Loss #3: Not considering tax-deferral for minor children: IRA trusts.

Little Boy Getting Money From An ATMFirst, it’s important to understand that minor children can’t own property, which means they can’t inherit property. This makes most beneficiary designations to minors invalid. There are some beneficiary designation forms which allow for a custodian to be appointed, but even these fall short because the child will typically get a full distribution of the funds at age eighteen (thereby creating a while other set of problems).

This problem is solved using a minor’s trust, which can be written directly into a will or revocable trust plan. A trustee is appointed who can accept property on a child’s behalf — the client then names the trust as the account beneficiary on the relevant beneficiary designation forms.

The big red flag with these trusts is that they must be written in a very specific way if they are going to be receiving qualified retirement assets. The trust must be a “see-through” trust for IRS purposes — it must be able to use the child’s life expectancy when calculating the required minimum distributions which all beneficiaries of inherited IRAs must take. If the trust does not meet IRS requirements for see-through trusts, or if a beneficiary of the trust is a non-human entity (like the estate or a charity), then the IRA must be cashed out within five years. Not only does this destroy the opportunity for tax-deferred growth, but the cash-out will likely be taxed at the trust’s astronomical tax rate (a trust hits it’s maximum tax rate at less than $15,000 in ordinary income per year).

Fortunately, the advisor is the ideal professional to make sure minors are not named directly as IRA beneficiaries. For those who miss this planning opportunity, a client’s tax hit may be all that is needed to ensure the next generation goes elsewhere for their planning needs.

A team-approach is the best approach to any financial plan. Financial advisors, CPAs, attorneys, banking specialists and insurance brokers all have an important role to play. Ensuring the plan is a cohesive one is a surefire way to make the client’s legacy a powerful and effective one — and to ensure a client’s family sees the value your firm adds for generations to come.

creates wills and trusts for families who want to feel secure that their loved ones are cared-for. Philip is a trust and estate attorney based in Minneapolis, Minnesota. Philip is the author of Trustee University: The Guidebook to Best Practices for Family Trustees, available at Amazon.com in paperback or Kindle edition (free chapter available here!). He also works with trustees and beneficiaries who need help with their trusts. You can contact him here.


You know estate planning has a lot of moving parts . . . guardianships and trustees for children, real estate and deeds, incapacity planning, charitable giving, business succession, and estate taxes are just a few concerns that clients have when putting together their plan. But one of the biggest problem areas comes from something entirely within the client’s (and their financial advisor’s) control . . . beneficiary designations.

Beneficiary designations operate independently of a will or trust document because these beneficiaries are named under a contractual agreement with the financial company. Life insurance, IRA accounts, brokerage accounts, and any other financial asset that allows the client to choose his or her beneficiary does so under contract law. At the client’s passing, these beneficiaries will receive the client’s funds regardless of what the client has written into a will or trust agreement. If a client has an ex-spouse listed as a beneficiary under a life insurance policy, but leaves everything to the current spouse in a will, then guess who gets the life insurance—the ex-spouse, unless the contract specifies otherwise

Last Will and Testament PapersAnd we like it that way! Beneficiary designations allow a convenient way to augment an estate plan. The assets are kept out of the probate courts and are paid to beneficiaries quickly and privately. Remember, probate is public—a will file can be pulled from the court records any time, along with any documents filed along with it. Probate is also expensive and emotionally draining. Non-probate beneficiary designations make this process easier and less expensive.

But this simplicity is a double-edged sword. Because these designations are simple and straight-forward, they are often taken for granted. Using the wrong beneficiary designations can cause an asset to go to probate when it would not have otherwise. It can cause adverse tax consequences. It can cause someone to receive money when they are in the midst of a divorce or bankruptcy proceeding, causing them to lose their inheritance. Beneficiary designations throw a wrench in estate plans specifically because they are so easy to change.

What are the biggest problem areas with beneficiary designations? Let’s look at the top five that I have experienced. The first is, hopefully, common sense:

Mistake #1: Not Keeping Beneficiary Designations Up to Date
Because beneficiary designations are a creature of contracts rather than estate planning law, they operate completely independently of a will or a trust agreement. If a life insurance policy has an ex-spouse listed as the sole beneficiary, then that is where the money is going. The current spouse can certainly sue the ex for the funds, but the chances of winning are slim . . . the benefit of the doubt goes to the person who made the beneficiary designation (and that person, now deceased, is typically not available to testify). If the beneficiary designation is so easy to update, and the client listed his or her ex, then clearly the client meant for these assets to go to his or her ex, right?

And we want to keep it that way. If angry would-be beneficiaries were to sue financial companies and win, those companies would probably stop letting us use beneficiary designations altogether. So it remains that if a client’s will says “leave everything to my spouse” and the life insurance beneficiary designations say “leave everything to my parents,” it’s going to the parents.

On that note, consider if the beneficiary designation were written so as to give the assets to a beneficiary who is not allowed to own property:

Mistake #2: Naming a Minor as Beneficiary
People who are under age eighteen can’t own property, which means they also can’t inherit property. This might seem like common sense when you think about it, and yet many (if not most) young families name their children as the secondary beneficiary on their financial assets. This beneficiary designations will fail, and an asset that otherwise
Little girl with moneywould have skipped the probate process will now go to probate court. An attorney will
work to get these assets into a conservatorship for the beneficiary, which is itself an expensive process. Perhaps even worse, the child will received the assets outright when they are still very young, typically at age eighteen. Have you seen an eighteen year old receive a lump sum of $100,000? I have. It doesn’t go well.

Some policies allow a custodian to be appointed when there is a minor beneficiary involved, which allows the custodian to accept the funds on the minor’s behalf. This solves the problem of the minor not being able to inherit property, but it does not solve the problem of the beneficiary receiving a very early inheritance.

The solution is often a simple one . . . a testamentary trust can be created directly in the client’s will, and the trust can be named by the client as the beneficiary of his or her financial assets. The trust only exists on paper unless it is needed, at which time it springs into existence and can accept funds on behalf of the beneficiary. The client can determine the terms of the trust . . . does the beneficiary get a lump sum at age twenty-five? Thirty? Never? While in trust, what can the trust pay for? Often college and health expenses are a top priority, with funds to pay for a first home or for a small business sometimes allowed as well.

Testamentary trusts solve all kinds of problems, and they’re not just for children. Trusts can be created for spouses, for charities, or for adult children with special needs. But sometimes the client doesn’t know who he or she wants to leave their money to, so they make a big mistake:

Mistake #3: Naming The Client’s Estate
First, let’s revisit the fact that assets with beneficiary designations skip probate, which means they skip the whole “estate” court process. This is often a good thing . . . though there are some merits to probate (particularly when there is a dispute), probate is expensive, time consuming, emotionally draining, and inefficient. Having a valid beneficiary designation makes this process easier because that entire asset skips probate altogether. Nonetheless, clients often want their life insurance policy, IRA, brokerage account, or other asset to just go to their heirs, so they write in that the assets should go to their “estate.”

This may seem convenient because the asset will now be controlled by the client’s will . . . which means it is now a probate asset. Not only does this cause the asset to go through probate, it can also has the effect of generating a lot of tax liability. If an IRA or other qualified asset lists anyone other than an individual as a beneficiary, then that entire asset must be paid out within five years. This can be caused in more ways than one . . . by naming an estate, or by naming a trust that is not a “see-through” trust for IRS purposes. If the trust does not qualify for this treatment, it accepts the entire IRA over five years. Tax-wise, this can be disastrous (note that if the trust does not make income distributions, this will be taxed at the much higher trust level).

And that brings up the next big point. Beneficiary designations have many consequences, not the least of which can be caused by:

Mistake #4: Lack of Tax Planning
To reiterate, leaving tax deferred, qualified assets to a non-individual can be murder on the100 Dollar money packs pocket book, since assets left to non-individuals must typically be paid out within five years. For tax-deferred money, this means the beneficiary’s effective tax rate can hit the stratosphere. Estates and trusts—or at least, trusts that weren’t drafted in anticipation of receiving qualified funds—are taxed at an astronomically higher effective rate than individuals.

Fortunately, trusts (including will-based testamentary trusts) can be drafted to be “see-through” trusts, which avoid the five-year distribution problem by allowing the trustee to collect required minimum distributions from inherited IRAs on the beneficiary’s behalf. This treatment is not available for assets left to an estate or if the trust has a non-individual as a beneficiary, such as a charity.

But on that note, consider a beneficiary who is charitably inclined. If there is one asset that should likely go to a charity, it is qualified funds. A qualified charity won’t have to pay taxes on funds received from tax-deferred sources like IRAs or 401Ks. A beneficiary will . . . IRA and 401K assets don’t receive the “step-up” given to appreciated non-qualified assets. If there is an opportunity to take advantage of the step-up in cost basis of other assets while leaving assets that would otherwise be taxed as ordinary income to a charitable beneficiary, it could be an incredibly effective tax strategy. Speaking of taxes:

Mistake #5: Forgetting About Credit Shelter Trusts
Minnesota has an estate tax exemption of $1.4 million per person in 2015, rising to $2 million by 2018 (though as of this writing, other proposals are in front of the legislature). The issue with the Minnesota estate tax exemption is that it is not portable . . . if one spouse dies and leaves their assets to the surviving spouse, the surviving spouse does not get to inherit the deceased spouse’s exemption, and therefore can’t “stack” the deceased spouse’s exemption on top of their own. This means the survivor could die with assets above and beyond his or her own estate tax exemption, paying tax on the difference.

The solution is to leave assets to a trust for the benefit of the surviving spouse (called a credit shelter trust). If drafted property, this trust will allow the deceased spouse to use his or her exemption, while still providing assets that can be used if the survivor needs them above and beyond the survivor’s own assets. This can save hundreds of thousands in estate taxes.

But this only works if the trust is funded. Too often clients pay an attorney to draft an effective credit shelter trust, and then they forget to leave assets to it. If the credit shelter isn’t given any assets, it’s going to be tough for it to shelter anything from estate taxes. Even financially savvy clients can sometimes forget about this aspect of their plan when there are dealing with the myriad of other aspects of their financial planning.

Of course, even proper planning doesn’t guarantee it will work if the client doesn’t keep up with it. Creating an effective testamentary or revocable trust only works if it is funded properly and if the assets with separate beneficiary designations are coordinated with the rest of the plan. A proper financial plan is broad, and estate planning is only one part . . . with the financial advisor as the captain, make sure the task of estate planning is given to a capable co-pilot who can make sure the client sees the big picture.

creates wills and trusts for families who want to feel secure that their loved ones are cared-for. Philip is a trust and estate attorney based in Minneapolis, Minnesota. Philip is the author of Trustee University: The Guidebook to Best Practices for Family Trustees, available at Amazon.com in paperback or Kindle edition (free chapter available here!). He also works with trustees and beneficiaries who need help with their trusts. You can contact him here.



When most people think of completing estate planning documents such as a will or trust
agreement, they think of how they would pass their assets to their loved ones. And indeed Rewardthat is the reason we create these documents, to make sure our loved ones are cared-for once we pass. But one of the best estate planning tools (to be used together with your estate planning documents) is to gift your assets to your loved ones while you are still alive. Lifetime giving has a number of benefits, both financially and otherwise.


Who doesn’t want to see the looks on the faces of those they care about most when their loved ones receive help with their student loans or with the down payment for their first home? Of course your family members would be grateful for receiving this same gift after your passing, but being able to revel in your family’s happiness is part of the reason we accumulate assets in the first place. Spreading the feelings of security and freedom that go with having some extra money is as fulfilling as any reason to share these gifts with your loved ones while you are able to witness their smiles first hand. A friend told me about the time they got a lovely watch for a partner. He found it on men’s watches online. Likewise, the beneficiaries of your gifts will get to share the experience with you. Just only give them this sort of present if this is something that they are in to. For example if you are getting a present for someone who is an avid gamer, then you should get them something like these unranked Smurfs accounts for them to enjoy instead.


As an attorney, I do my best to keep costs under control for my clients. This ensures that the client feels he or she has received value for my services while I am able to maintain an efficient client relationship. Nonetheless, lawyer fees are lawyer fees, and if I am working to transfer property with the help of a probate judge, that is going to cost your beneficiaries money. If you transfer that car, those stock shares, or that cash while you are alive, you’re going to save some attorney fees because it is easier to transfer property while you are still alive. People often want to avoid the probate process specifically because it can be expensive.

Estate Taxes

This applies more to large estates than small or medium estates, but paying federal gift taxes on a transfer of property is cheaper than paying estate taxes for the exact same transfer after death. This is true even though the exclusion amounts and tax rates for these two taxes are identical. This is because gift taxes are exclusive, while estate taxes are inclusive. When I transfer money or assets by making a lifetime gift and owe federal gift taxes, those taxes are going to be paid by me, and will then be out of my estate . . . that tax money I just paid is now out of my estate for good, and will itself not be taxed . . . it will be excluded. If I make these gifts at death via my will or other estate planning vehicle, that tax is assessed on my gross estate. That means the money I will have to use to pay my estate taxes will itself also be taxed: it’s included. Lifetime gifts will therefore be subject to fewer federal estate taxes than those made at death because the money used to pay the estate taxes is also itself subject to taxation. I’ll emphasize that this benefit does not apply to most Americans . . . the current federal and estate tax exemption, as of this writing, is $5,340,000 per person, which means its $10,680,000 for a married couple. That’s some big gifts that you’ll have to make before you owe any federal gift or estate taxes.


When you hold on to an asset that appreciates in value, eventually you may have to deal with estate taxes which will be assessed on the value of that asset at your death. If you have an asset that you believe will appreciation significantly over your lifetime, consider making a lifetime gift to a beneficiary or to a trust for a beneficiary. For example, if you started a small business and you owned closely-held shares of that business, you may consider giving some of these shares to your children today (taking into account possible gift tax issues). That way, as the business appreciates in value, those shares will also appreciate out of your estate.

Proceed with Caution

There are a couple tax rules that will apply to most people. First, gifts of appreciated property made after-death get a huge tax break in the form of a step-up in cost basis. If I were to buy a share of stock for one dollar (which means the stock has a cost basis of one dollar) and it increases in value to $100 and I sell it, I’ll owe capital gains taxes on $99 (the sale price minus the cost basis of one dollar). This is because the sale of the stock realized a capital gain of $99. If buy that same share of stock for one dollar, then it increases to $100 and I give it to my family member, they will keep my same cost basis. Because of this, if my family member subsequently sold it they would again realize that same $99 capital gain, and would owe capital gains taxes. If, however, I gave that same share of stock to that same family member after my death, that capital gain would “reset” . . . the new cost basis would be the value of the stock on the day I died. That means if I buy a share of stock for one dollar, it appreciates and is valued at $100 when I die, the family member who gets that share of stock now has a cost basis of $100. If he or she sells it for $100, it is completely free of capital gains taxes. This step-up in basis is a valuable estate planning tool, and is ideal for property that has appreciated significantly.

Note that this would not apply to assets that do experience capital gains, such as cash. Note also that qualified charities can receive shares of appreciation stock (or other assets) and sell these assets for cash and pay no taxes whatsoever. This is because qualified charities are tax exempt, which includes capital gains taxes. Assets that have appreciated in value are usually best given to charities or to your heirs at your passing.

Another thing to watch out for is the annual gift tax exclusion amount, which is as of this writing $14,000. This means you can give up to $14,000 per year, per person. You could give $14,000 to each of your children, another $14,000 to any of your friends, etcetera. If you exceed this amount to any single person, you will typically have to file a gift tax return (Form 709) with the IRS. This is because any amount you gift to any one person over $14,000 gets subtracted to your lifetime exemption ($5,340,000, as mentioned above). The IRS wants to track how much of your lifetime exemption you have used. You may not owe tax, but you’re still going to have to file the form

Your Plan

Making lifetime gifts is a satisfying and generally straight forward method of estate planning. It helps your family today while possibly saving on taxes. But beware of pitfall — there are rules about how much you can give without running afoul of some complex gift and estate tax rules. Lifetime gifts are to be used in conjunction with — and not instead of — a comprehensive estate plan. A qualified estate planning attorney can guide you through these rules. I’m here to help.

creates wills and trusts for families who want to feel secure that their loved ones are cared-for. Philip is a trust and estate attorney based in Minneapolis, Minnesota. Philip is the author of Trustee University: The Guidebook to Best Practices for Family Trustees. available at Amazon.com in paperback or Kindle edition (free chapter available here!) He also works with trustees and beneficiaries who need help with their trusts. You can contact him here.

Keywords: trusts and estates, Minnesota wills, revocable trusts, estate attorney, probate, estate planning

A trustee is the individual you will appoint to manage the assets of your trust and to make sure the instructions you leave in the trust document are appropriately interpreted and followed.  When a beneficiary approaches the trustee and asks for trust funds, should the trustee make the distribution?  Perhaps as importantly, what should the trustee not pay for?

Holding piggy bankTypical trust language allows the trustee broad discretion when making distributions.  For tax planning, the IRS allows a trustee to make distributions for “health, education, maintenance, and support” (or some combination of those four words) — called an ascertainable standard or a HEMS standard — without causing the distribution language to have estate tax problems.  But what do those words really mean?  If your trustee doesn’t know your feelings on trust distributions, then the trustee may turn down requests from trust beneficiaries that you may wish the trustee to make.  Perhaps worse, the trustee may make distributions that you do not want made.


One of the most important things for a trust to pay for is health expenses.  These could be limited to such things as emergency health care or prescriptions, or it could be broad enough to include routine check-ups.  “Health” is a legal term of art in trust drafting — it does not typically cover health insurance expenses, so you will want to make sure your attorney knows whether you wish for the trust to cover these expenses or not when you are having your trust drafted.


Your trust can be used to pay for your beneficiary’s college education.  When it comes to trust language, “education” is another legal term of art . . . it typically means a two- or four-year college degree.  Many trustees will give some leeway to this language and will allow funds to be used for technical school as well.  What it does not typically cover, unless defined elsewhere in the document, is graduate school or other professional training.  Make sure your document defines what “education” means so that there is no confusion.

Support and Maintenance

In trust lingo, support and maintenance really means “living expenses;” your trust can be used to pay for the daily living expenses of your beneficiary.  This can be a bit of a double-edged sword; we don’t want to leave our beneficiaries out in the cold if they lose their jobs or if they incur unexpected or urgent expenses.  On the other hand, being allowed to take a monthly stipend from trust fund can have the effect of creating a lazy and unmotivated beneficiary.  Beneficiaries may also come so used to trust funds supplementing their income that when the trust runs dry, they are unable to adjust their standard of living.  You may want to require your trustee to take into account your beneficiary’s outside resources before making a distribution.  Also consider a trustee making distribution to a beneficiary who struggles with substance abuse; these distributions could do more harm than good. Your estate attorney can advise you on proper distribution language for virtually any special circumstance.

Comfort and Reasonable Luxuries

Recall that the “HEMS” standards outlined above limit a trustee’s expenditures in order to protect the beneficiary from estate taxation problems.  When estate taxes are not a concern, trusts may become much more liberal with distributions.  Language referring to comfort and reasonable luxuries allows the trustee to make distributions outside of what is typically allowed under the HEMS standard, such as vacations, a nicer car, a better home, and perhaps some gifts.  Attorneys may add additional language that can customize the distributions a trustee may make, allowing you to create a trust that truly fits the needs of your beneficiaries.

Ultimately the trustee will make distributions based on a number of factors, such as the purpose and size of the trust, the intended duration of the trust, the ages of the beneficiaries and their anticipated financial needs later in life, the requirements and expectations of future trust beneficiaries, etcetera.  But you will get the trustee started on the right foot if your trust language and trustee instructions are clear.  If you are interested in learning more about how you can set up your trusts, please contact me.

creates wills and trusts for families who want to feel secure that their loved ones are cared-for. Philip is a trust and estate attorney based in Minneapolis, Minnesota. Philip is the author of Trustee University: The Guidebook to Best Practices for Family Trustees. available at Amazon.com in paperback or Kindle edition (free chapter available here!) He also works with trustees and beneficiaries who need help with their trusts. You can contact him here.

Keywords: trusts and estates, Minnesota wills, revocable trusts, estate attorney, probate, estate planning

If you’re like most Americans, the bulk of your liquid assets are held in retirement plans such as a 401(k) or an Individual Retirement Account (IRA).  These are great places to stash retirement funds — company matches and tax-deferred growth (or tax-free growth, in the case of Roth plans) jump-start these savings plans in a way not available for non-retirement assets.  If used properly, this will create a comfortable retirement nest egg that will carry you through your post-career life.

401k - Nest EggBut what happens after that?  There is a good chance that at least some of these assets will outlive you, and you may have other family members to care for (such as a surviving spouse).  The tax-deferred nature of qualified retirement funds presents unique challenges and opportunities for your family as you contemplate your estate planning.  The biggest thing to consider is who you will list as the beneficiaries of these plans; as far as taxes are concerned, all beneficiaries are not created equal. Speaking strictly from the standpoint of tax liability, the best beneficiaries are charities, followed by a surviving spouse, then other family members, and lastly (and definitely least), outright to your estate.

First, understand that marketable assets such as stocks and bonds receive a step-up in cost basis at the death of the owner.  Consider if I bought a share of stock for $1, and then the value of that share few to $100 and I sold it.  During my life, I would have to pay capital gains tax on the $99 gain I received from this sale (the sale of the stock at $100, less my cost basis of $1).  If instead I died and left the share of stock to a child, the child gets a new cost basis of the value of the share of stock when I died. If that value was $100, then the child gets that share of stock with a cost basis of $100.  If he or she then turned around and sold that share for $100, that child has received the stock completely tax-free, assuming my estate is below federal estate tax levels.  The step-up in basis erased any capital gains and the tax liability that would have gone with those gains.

Those same assets held in a tax-deferred retirement plan such as a 401(k) or IRA do not receive this step-up in cost basis . . . all distributions from these retirement funds, whether they be to you or to a beneficiary, are taxed as ordinary income when they are withdrawn from the retirement plan.  If I make $50,000 from my job, and I receive $10,000 from a tax-deferred retirement fund, then I pay taxes as if I made $60,000.  That’s going to be much more tax than if I instead received an inheritance from assets that are not taxed as ordinary income (such as an after-tax brokerage account).

Because these gifts contain built-in tax liability, tax-deferred retirement assets are the best assets to give to charities, if you are charitably-minded.  Because qualified charities do not pay any taxes on gifts they receive, they are the ideal beneficiaries of any estate asset that carries income or capital gains tax liability because your gift to goes further than if it were given to someone who will have to use a part of that gift to pay taxes.  This makes qualified charities the perfect beneficiary of high-tax assets such as tax-deferred retirement assets.

For those not so inclined, you should next consider leaving these assets to your spouse.  Your surviving spouse will be able to treat qualified retirement assets as if they were part of his or her own retirement account . . . this typically means he or she could defer taking distribution (and owing income tax) until the spouse 70 ½ years old, which is the age at which individuals are required to begin taking their required minimum distributions (RMDs) from qualified plans.  Even then, they will only be require to pay taxes on the required minimum distribution amount (an amount that is calculated based on the surviving spouse’s life expectancy), and will enjoy continued tax-deferred growth for the assets that remain in the retirement plan.

If you would prefer to leave your qualified tax-deferred plan to another individual such as an adult child, understand that unlike your spouse, a child will not be allowed to defer the RMD distributions until he or she turns 70 ½; the child will be required to begin taking RMDs from the plan immediately.  This can pose some problems if the child is in a high income tax bracket because your gift to them will be diminished substantially by the income taxes he or she incurs at his or her effective tax rate.  But assuming the child does not take large additional distributions from the account (which would incur even more taxes), the majority of the assets will continue to enjoy tax-deferred growth.  You can also work with an attorney to set up a trust which, if properly drafted, can accept the RMDs from the account on behalf of the child, which can then me managed by a trustee.  This is a great option if the child requires assistance in managing money.

The least preferable option, and one that occurs all too often, is to either leave the assets outright to an estate, or to a trust that is not properly structured to receive retirement distribution for a beneficiary.  If this happens, the entire account must become payable to the estate or trust within five years.  Estates and trusts have much smaller tax brackets (resulting in much higher effective tax rates) than individuals, and income tax liability can be devastating. A substantial distribution to an estate or improperly drafted trust could result in half of the gift disappearing into the hands of the tax man.

This is not to imply that someone should turn their nose up at a gift of retirement assets from a family member!  Speaking personally, I would certainly take a taxable gift over no gift at all.  But it’s worth talking about the ideal recipients of gifts from tax-deferred retirement plans so that you can maximize the gifts you make to your family members. Proper primary and secondary beneficiary designations are a key part of any estate plan, and part of what you are paying your estate planner to do.  Ensuring that you select the proper beneficiaries for your plan will give you and your family the peace of mind you deserve from your years of hard work and saving.

creates wills and trusts for families who want to feel secure that their loved ones are cared-for. Philip is a trust and estate attorney based in Minneapolis, Minnesota. Philip is the author of Trustee University: The Guidebook to Best Practices for Family Trustees. available at Amazon.com in paperback or Kindle edition (free chapter available here!) He also works with trustees and beneficiaries who need help with their trusts. You can contact him here.

Keywords: trusts and estates, Minnesota wills, revocable trusts, estate attorney, probate, estate planning