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Retirement benefits, such as pension and profit sharing plans, 401(k) plans, teacher retirement plans, and individual retirement accounts (IRAs), represent an increasingly large portion of many estates. Unfortunately, the rules governing contributions to and distributions from qualified plans and IRAs can be complicated. Also, what makes sense for one person, based on his or her specific circumstances, might not be appropriate for another person. Finally, often there is tension between the best planning from an income tax standpoint and the best planning from an estate tax standpoint.
Subject to these cautionary notes, here are ten tips from our estate planning professionals on how to deal with your retirement benefits:
Tip #1 – Maximize Your Contributions
Qualified plans and IRAs allow tax-free compounding of income and gains over long periods of time. At an 8% annual return (interest, dividends and capital gains), a single $5,000 IRA contribution will grow to over $100,000 over 40 years. Contributions of $5,000 per year will grow to nearly $1.3 million over 40 years. Contributions to pension, profit-sharing and 401(k) plans can be substantially greater than the $5,000 per year limit for IRA contributions.
A common misconception is that by contributing to a retirement plan, you are converting capital gains to ordinary income, or giving up the opportunity to take advantage of the 15% tax rate on qualified dividends and capital gains. But the effective tax rate on income and gains in an IRA is zero. For example, suppose you contribute $5,000 to an IRA. Over some period of time, it grows to $50,000. If you are in a 30% tax bracket, and you withdraw the $50,000, you will have $35,000 remaining after income taxes. If you instead paid $1,500 tax at the beginning, and invested the remaining $3,500 in your taxable account, you would need a zero tax rate on your investment income for your $3,500 taxable account to grow to the same $35,000.
Tip #2 – Convert to a Roth IRA When Possible
Converting to a Roth IRA is generally advantageous. It is effectively the same as making a substantial additional contribution to your IRA. For example, suppose you have a $100 IRA and $30 of other money. You convert your IRA to a Roth IRA, and use your $30 of other money to pay the income tax on the conversion. You now have a $100 Roth IRA. Over some period of time, it grows to $200, which you can withdraw free of income tax. Over the same period of time, if you did not convert to a Roth IRA, your $100 IRA will grow to $200. If you withdraw the $200, you will pay $60 tax, and will have $140 after income taxes. You would need a zero tax rate on your investment income and gains in order for your $30 taxable account to grow to the same $60.
The Roth conversion offers at least two other important tax benefits. First, there are no required distributions from a Roth IRA during lifetime. Since many people (or their surviving spouses) live well beyond age 70 ½, the ability to avoid required distributions during lifetime can be significant. Second, if an IRA owner intends to leave the IRA in trust rather than outright, the benefits are subject to the compressed income tax brackets for trusts to the extent they are retained in the trust. Since Roth IRA benefits are generally not subject to income tax, this is not an issue with a Roth IRA.
In order to be able to convert to a Roth IRA, an IRA owner's modified adjusted gross income cannot exceed $100,000, without regard to the income from the conversion. Required distributions from an IRA do not count for this purpose. Beginning in 2010, the $100,000 income cap will no longer apply. This will enable more IRA owners to convert to Roth IRAs.
Tip #3 – Keep the Assets in the Retirement Plan or IRA as Long as Possible
Qualified plan participants and IRA owners must generally begin taking benefits at age 70 ½. However, the benefits can be stretched out over a long period of time. Participants and IRA owners should generally use their other assets first, so as to take advantage of the income tax benefits of keeping as much money as possible in the retirement plan or IRA. On the other hand, participants and IRA owners should give consideration to utilizing their lower income tax brackets. An IRA owner in a low income tax bracket can utilize his or her lower income tax brackets while keeping the assets in the IRA by converting some or all of the IRA to a Roth IRA.
Tip #4 – Coordinate Beneficiary Designations with Your Estate Plan
Many participants and IRA owners have sophisticated wills or revocable trusts that contain detailed provisions disposing of their assets, as well as detailed administration provisions. These documents also contain provisions that are carefully designed to minimize income and estate taxes and to protect assets from the claims of creditors.
An IRA is often someone's largest single asset. It passes in accordance with the beneficiary designation, not the terms of the owner’s will or revocable trust. Often very little thought is given to the beneficiary designation. This can result in additional estate tax, the loss of the ability to stretch out the benefits, and the loss of asset protection.
Participants and IRA owners should coordinate their beneficiary designations with the rest of the estate plan. They should also consider naming contingent beneficiaries where appropriate.
Tip #5 – Leave the Retirement Benefits to the Spouse Where Appropriate
There are income and estate tax benefits to leaving qualified plan and IRA benefits to a surviving spouse. The benefits qualify for the estate tax marital deduction. The spouse can roll them over into his or her own IRA, name new beneficiaries, possibly convert to a Roth IRA, and obtain a longer period of time over which taxable distributions must be paid. Paying qualified retirement plan and IRA benefits to a trust for the surviving spouse that qualifies for the estate tax marital deduction provides control over the principal, but gives up these planning opportunities. At most, payment of the benefits can be extended, or “stretched out,” over the surviving spouse's life expectancy. Thus, in most cases, participants and IRA owners should consider leaving their retirement benefits to the surviving spouse outright.
Tip #6 – Coordinate Retirement Benefits With the Exclusion Amount Trust
A common planning technique used by married persons is to provide in a will or revocable trust that upon one spouse’s death assets worth the maximum amount that may be transferred and excluded from estate tax (in addition to transfers that qualify for the marital deduction and the charitable deduction) will pass to a trust. This type of trust is sometimes referred to as the family trust, the credit shelter trust, or the exclusion amount trust. The assets of the trust may be held for the surviving spouse’s benefit but because the surviving spouse does not own the assets, they will not be subject to estate tax upon the surviving spouse’s death.
Some participants and IRA owners do not have enough other assets to fill up the exclusion amount trust, and want to leave some or all of the retirement plan or IRA benefits to their exclusion amount trusts. This situation is more common now that the estate tax exclusion amount has increased to $2 million and will increase to $3.5 million in 2009.
If retirement plan or IRA benefits are payable to the exclusion amount trust, they must be paid out over the surviving spouse's life expectancy (at most). The participant or IRA owner must choose between the income tax benefits of leaving the IRA to the spouse and the potential estate tax benefit of fully funding the exclusion amount trust. One way to do this is to provide on the beneficiary designation form that the exclusion amount trust is to receive the amount necessary to fully fund it, after taking into account the participant or IRA owner's other assets. Another approach is to leave the retirement benefits to the spouse, who can disclaim them to the extent necessary to fill up the exclusion amount trust (or to whatever extent, if any, the spouse chooses).
Tip #7 – Leave the Retirement Benefits to Children or Grandchildren Outright Instead of in a Discretionary Trust
For a number of reasons, many people prefer to pass an inheritance to their children and grandchildren in trust rather than outright. If the trusts are structured properly, the trust assets will be protected from the beneficiary's potential creditors (including spouses) and will not be included in the beneficiary's estate. Trusts also separate the control from the beneficial ownership, and provide greater income tax flexibility.
The same reasons for leaving assets in trust apply in the case of retirement benefits. However, the period of time over which distributions can be extended, called the “stretchout period,” is limited to the life expectancy of the oldest beneficiary of the trust. In other words, no accumulated IRA benefits can ever go to anyone older than the designated beneficiary. Even remote contingent beneficiaries are counted for this purpose. Unless the IRA owner is willing to subject the other assets to this restriction, this means that the IRA benefits must be segregated in a separate trust. The trust or trusts that receive the IRA benefits can be created under a will, a revocable trust, or in a separate trust document.
If the IRA benefits must be paid out each year, and cannot be accumulated, then subsequent beneficiaries can be disregarded. However, in that case, if the beneficiary lives to life expectancy, then nothing will remain in the IRA or the trust, and all of the protection of the trust will be lost.
Tip #8 – Don’t Collect the Benefits Upon Death and Destroy the Stretchout Period
A beneficiary can generally stretch the benefits out over his or her life expectancy. The benefit can be significant for younger beneficiaries. However, sometimes a beneficiary collects the benefits before realizing that he or she could have stretched them out over his or her life expectancy.
There is no provision allowing a beneficiary other than a spouse 60 days to roll the benefits over into an IRA. Beneficiaries should always consult a tax advisor to become aware of the potential stretchout period before collecting the retirement benefits.
Tip #9 – Don’t Collect the Benefits Before Considering a Disclaimer
As in the case of other assets, beneficiaries sometimes choose to disclaim (refuse to accept) retirement benefits. If the named beneficiary disclaims, the retirement benefits will go to the contingent beneficiaries, or if none then in accordance with the default provisions of the plan or IRA, or if none then to the participant's or IRA owner's estate.
A beneficiary may wish to disclaim retirement benefits to allow them to go to the spouse to obtain the marital deduction, and to permit the spouse to roll them over into his or her own IRA, name new beneficiaries, possibly convert to a Roth IRA, and obtain a longer stretchout period. A spouse may wish to disclaim retirement benefits to allow them to go to the exclusion amount trust, or to or in trust for the children, to save estate taxes in the spouse's estate. A child may wish to disclaim retirement benefits to allow them to go to the grandchildren, so as to keep them out of the child's estate, and to obtain a longer stretchout period.
Tip #10 – Consider a Spousal Rollover Even if the Spouse is not the Named Beneficiary
As mentioned above, there are significant benefits to naming the spouse as beneficiary. The spouse can roll the benefits over into his or her own IRA, name new beneficiaries, and possibly convert to a Roth IRA. But sometimes the spouse is not the named beneficiary.
The IRS has issued numerous private letter rulings allowing a spousal rollover where the spouse was not the named beneficiary. For example, the retirement benefits may pass to the spouse under the default provisions of the qualified plan or IRA. Or the IRA may go to the spouse as a result of a disclaimer, by intestacy, as marital property, or through an estate or a trust in which no one other than the spouse can cause the retirement benefits to be payable to anyone other than the spouse. Thus, just because the spouse is not the named beneficiary does not mean that you can't get the retirement benefits to the spouse so as to permit a spousal rollover.
If you have questions about your retirement plans or IRAs, please feel free to contact any of our estate planning professionals.
© 2008 Ruder Ware, L.L.S.C. Accurate reproduction with acknowledgment granted. All rights reserved. |
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