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.
But 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from these retirement funds, whether they be to you or to a beneficiary, are taxed as ordinary income when they are withdrawn from the retirement plan.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.
Philip J. Ruce 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