Investor Education – Estate Planning
Are Your Beneficiary Designations Up-to-Date?
Are your will, durable powers of attorney and health care directive up-to-date? If so, you have made a great start in managing your wealth. These documents are part of the foundation for effective wealth management, but you should also review all of your beneficiary designations to make sure that they reflect your current plans for passing along wealth to family, friends and charities.
Your will provides the blueprint for distributing your probate estate. But for most people, a very substantial portion of their total wealth will pass to others through avenues other than their will. These other assets will pass according to the titling of assets (i.e., joint tenants with right of survivorship or transfer on death accounts) and the beneficiary designations on various accounts and insurance contracts. A regular review and update of these beneficiary designations is critical to effective wealth management.
Decisions about beneficiary designations are not always obvious. Married individuals may instinctively choose their spouse as their beneficiary on all insurance policies and retirement accounts. This may be a natural choice whenever these funds will be needed to maintain the standard of living of the surviving spouse. However, in some cases it may be appropriate to have these funds pass to children or grandchildren. For instance, an irrevocable trust that owns the life insurance on your life will enable you to create a pool of wealth that will pass to the next generation completely free of income, estate and gift taxes.
Married couples who have sufficient wealth to pass along assets to charities, children or grandchildren at the time of the first death should consider naming these charities or family members the beneficiaries of their IRAs and other retirement accounts. Distributions from traditional IRAs and other retirement accounts represent taxable income to the recipient. This is true for distributions taken by the plan participant during his or her life as well as distributions made to the beneficiaries after the death of the plan participant. A beneficiary is permitted to withdraw the funds from the deceased’s IRA or other retirement plan over his or her own remaining life expectancy. As a result, the younger the beneficiary, the slower the rate at which the IRA or retirement plan is taxed as its balance is depleted. This creates an excellent opportunity for tax-deferred growth within the account by naming a young beneficiary. IRAs and other retirement plans are also excellent funding vehicles for charitable bequests. Because qualified charities are exempt from income tax, these plan balances are often the first source for meeting the charitable intentions of the deceased.
A spouse is typically required to waive his or her rights to benefits from a qualified retirement plan in order to name a non-spouse beneficiary. As a result, a married couple must make this decision jointly. While this strategy may make sense for many plan participants, there are a few potential pitfalls when naming a non-spouse beneficiary of retirement plans, such as 401(k), 403(b), 457 and other plans (other than IRAs).
Plan administrators are not obligated to continue paying the required minimum distributions throughout the remaining life of the beneficiary. In many cases, the plan administrator does not want the additional responsibility and expense of managing these balances after the death of the former employee. As a result, the plan administrator typically pays the entire plan balance to the beneficiary shortly after the death of the participant. This does not create a significant problem when the beneficiary is a spouse. A surviving spouse is allowed to roll over distributions from a deceased participant’s retirement accounts into an IRA and thereby avoid immediate taxation. However, non-spousal beneficiaries do not have this IRA rollover option. Unfortunately, the non-spousal beneficiary of one of these plans must pay income taxes on the entire plan balance in the year of the distribution. This distribution frequently pushes them into the highest income tax bracket, significantly reducing the available funds.
For this reason, it may be a good idea for people with significant assets spread among various retirement plans to transfer these plan balances into rollover IRAs. Taking this important step during your life will eliminate the onerous income tax consequences of a lump-sum distribution to a non-spousal beneficiary. Even more important, a rollover IRA will give you significantly more control over your investment options and enable you to construct a well diversified portfolio.The IRS has recently indicated that non-spousal beneficiaries may soon have the flexibility to use an annuity to spread out retirement plan payments over many years. While this is a positive development, it is still not as effective as a rollover IRA.
Now is a good time to review all of your beneficiary designations, especially for your retirement accounts, and to consider the benefits of a rollover IRA. There are other factors that should be considered when exploring this alternative, including the creditor protection that your state of residence extends to IRAs. Qualified retirement plans have historically been given a very high level of protection from creditors. Most states have enacted legislation that extends similar creditor protection to IRAs, but you should discuss this matter with your attorney if you are concerned that a rollover IRA might not provide sufficient creditor protection.
For more information on this topic, please contact us. At Bartlett & Co, we assist high net worth individuals and their families in defining & reaching their life goals.