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Leaving Your Retirement Fund Behind

Have you selected Uncle Sam as the primary beneficiary of your retirement plan?

Under the current income and estate tax system, the retirement plan of a wealthy American may be taxed at more than 66 percent at his or her death! Those who are charitably inclined, married or with younger heirs can eliminate, defer or reduce that tax bite.

Retirement funds are subject to both income and estate taxes when they are paid to a decedent’s estate. Fortunately, the Internal Revenue Service has a rule to mitigate double taxation. One of the most significant, yet easily overlooked, deductions is the estate tax paid deduction. In the year that a beneficiary receives a qualified plan distribution, the distribution is subject to income tax. However, each recipient is entitled to an itemized deduction for the pro-rata share of estate taxes paid on his or her portion of the distribution. Consider Harold Stevens. Hal has been married to his wife, Andrea, for 15 years. He has two children from a previous marriage, Marcus and Jennifer, and three grandchildren. Hal was a successful plaintiff’s attorney in private practice until he retired 10 years ago. He did not have a traditional corporate pension plan. But beginning in the early 1980s, Hal began socking away money in a retirement plan. Today, at age 75, Hal’s Individual Retirement Account balance is $2 million.

If Hal dies with no beneficiary planning, Andrea, who is 70, will inherit his IRA despite the fact that Hal intends his children to inherit this asset. Andrea has three options: 1) Treat it as her own IRA by designating herself the account owner or rolling it over into her traditional IRA or other qualified plan, 2) Treat herself as the beneficiary and transfer assets to an Inherited IRA Beneficiary Distribution Account (inherited IRA), or 3) Refuse to accept it. The first two options defer payment of estate taxes until Andrea’s death. The third option may subject the IRA to estate taxes at Hal’s death.

If Andrea treats Hal’s IRA as her own, she may take distributions as soon as she likes, but regardless of her preferences, she must begin taking distributions soon after she turns 701?2. If Andrea withdraws money from the IRA before she reaches age 591?2, she will be subject to a 10 percent early withdrawal penalty in addition to regular income taxes on the distribution.

Andrea could instead opt to transfer Hal’s IRA into an inherited IRA. Distribution amounts from the inherited IRA will be based on Andrea’s age, but the beginning date of distributions will be based on Hal’s age at death. Because he was already receiving distributions, Andrea’s distributions would commence immediately. This option is most appealing when the surviving spouse is under 591?2 and wants to withdraw some funds from the IRA without an early withdrawal penalty.

Regular income taxes will be paid on the annual distribution. Afurther option for Andrea is to disclaim (refuse to accept) all or a portion of Hal’s IRA; she has nine months from the date of his death to do so. If the contingent beneficiaries are of a younger generation and Andrea has sufficient assets for the remainder of her life, this strategy could make sense.

In this case, the contingent beneficiaries are Hal’s children, Marcus and Jennifer. They cannot treat the inherited IRA as their own. They would be required to begin receiving minimum distributions from the IRA under the rules for distributions that apply to non-spouse beneficiaries. These rules require the distributions to be based on the oldest child’s life expectancy. Marcus and Jennifer are 30 and 32 years younger than their father, respectively. The minimum required distribution amount would be substantially lower than their father’s would be, and therefore the compounding of the tax deferral would have a greater effect. However, the effect for Jennifer would be slightly reduced because she would be required to receive distributions based on Marcus’ age. The children can circumvent this by splitting their inherited IRA before Dec. 31 of the year following the year of the original owner’s death. Once the IRA is split, each child may calculate his or her minimum distribution amount based on his or her own life expectancy.

Hal adores his children and wants assets to pass to them at his death, as tax-efficiently as possible. But his son didn’t inherit Hal’s sense of responsibility and financial savvy. Marcus has struggled with credit problems his entire adult life. Jennifer, on the other hand, is a paradigm of financial responsibility.

Taking these facts into consideration, an advisor may suggest that Hal leave a portion of his retirement plan to a “look-through” trust and a portion to a conduit trust. A look-through trust permits the funds to remain in trust, whereas the conduit trust requires distribution. Any portion of the retirement plan exceeding the estate tax unified credit will be subject to estate taxes at Hal’s death. If the beneficiary is a trust that qualifies as a “look-through” trust, the retirement account pays annual installments over the life expectancy of the oldest trust beneficiary. A lookthrough trust must be valid under state law, have named and identifiable individual beneficiaries and be irrevocable at the owner’s death. The retirement distributions would be subject to income tax at the trust level. Trusts reach their highest marginal tax rates at amounts much lower than those for individual income taxpayers. To avoid paying taxes at the trust level, the trustee could distribute the income to the trust beneficiaries. This taxes the distributions at individual income tax rates. Trustees maintain discretion in these trusts, thus limiting the amount that a young or financially unwise heir controls.

Alternatively, Hal could leave his retirement assets to a conduit trust. A conduit trust is required to distribute the entire annual retirement distribution to the individual beneficiaries, net of trust administration expenses. However, the retirement distribution can be allocated to the individual beneficiaries in amounts determined by the trustees. This trust also allows for a non-individual beneficiary, such as a charity.

If the trust receiving the retirement account has more than one beneficiary, Hal should consider establishing separate trusts for each beneficiary’s share so that each beneficiary can use his or her own life expectancy to calculate minimum distribution amounts.

Hal’s success and sound investing have left him with a $10 million estate. He believes $8 million is more than enough to provide for his heirs and would like $2 million to go to charity. He can escape paying both estate and income taxes on retirement funds he bequeaths to charity.

To illustrate, Hal has $2 million of retirement funds and $8 million of non-retirement securities. He would like to bequeath $ million of his estate to charity and $8 million to his family. If he splits his assets proportionally, the charity receives $400,000 of retirement funds and $1.6 million of securities tax-free, and the estate receives $960,000 of retirement funds (after paying $640,000 of income tax, assuming a combined federal and state tax rate of 40 percent) and $6.4 million of securities. Alternatively, if the charity received $2 million of retirement funds, the estate would receive $8 million of securities, and the $640,000 of income tax could be avoided.

One may bequeath a portion of a retirement account outright to a charity and the remainder to individuals via look-through trust. The portion donated to charity passes free of income and estate taxes. The portion that passes to individual beneficiaries will defer income taxes.

One may also leave a portion of retirement assets to a charitable remainder trust (CRT). ACRT is an irrevocable agreement established to provide income to the grantor or beneficiaries and leave the remainder interest to designated charities. ACRT does not pay income taxes. The assets bequeathed to the CRT would be invested, and income generated by the CRT would be distributed to the individual beneficiaries of the trust and taxed on their individual returns. Bequeathing retirement assets to CRT can significantly reduce estate taxes because the estate receives a charitable deduction for the remainder interest.

Estate taxes, income taxes and retirement plans are a dangerous mix. Most retirement plan distributions will be entirely taxable at distribution, but the tax results can vary greatly. Careful planning can make those retirement dollars go a lot farther.

Senior Client Service Manager Rebecca Pavese, based out of Atlanta, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 2, “Relationships With Adult Children”; Chapter 3, “Planning For Incapacity”; and Chapter 7, “Grandchildren.” She was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.
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