For many people a large part of their estate is their Retirement Plan, whether it is a qualified plan or an individual retirement account (IRA) or both. The retirement plans and accounts benefit their owners because income taxes are deferred and money can thus accumulate tax-free. However, the monies distributed from these plans and accounts are subject to income taxes at the time of distribution. To effectively use these plans and accounts, it is often wise to delay distributions in order to minimize taxes and to allow the monies in the plans and accounts to grow tax-free.
Tax-deferred retirement plans and accounts can be traps for the unwary. Before any distribution is made, the simple act of naming a beneficiary of the retirement plan or account proceeds can have vast ramifications for both the owner and the beneficiary. As distributions begin, deciding how to calculate payments will not only affect the owner's distributions and resulting income taxes, but will also have repercussions for any beneficiaries after the owner's death.
The beneficiary designation not only determines who will be entitled to receive the proceeds after the owner's death, but will affect the term and amount of the owner's required distributions. The distributions may be determined based upon a joint life expectancy of the owner and the beneficiary, which may lengthen the period over which distributions will be made and thus reduce the amount of each distribution and possibly lower the tax bracket. Additionally the assets remaining in the retirement plan or account will continue to grow tax-free until distribution.
The beneficiary designation will also affect where the retirement funds are distributed at the death of the owner because the beneficiary designation--not the owner's will--determines who benefits from the retirement fund at the owner's death. If you do not coordinate the objectives and goals of your estate plan with your retirement plan or account beneficiary designation, those objectives and goals may not be realized.
For example, assume you and your spouse have chosen an estate plan which is intended to shelter the federal estate tax credit (this year $625,000) at the first spouse's death in a Family Trust. The Family Trust is designed so that if the surviving spouse needs additional funds they are available through the Family Trust. Now assume at the first spouse's death his or her estate consists primarily of a retirement plan which names the surviving spouse as the beneficiary and the children as the contingent beneficiaries. If the surviving spouse remains the beneficiary, the retirement plan or account assets will be included in his or her taxable estate. If the surviving spouse disclaims his or her rights to the plan or account, the assets will go to the children, thereby precluding the spouse from any access to the funds which would have been allowed through the Family Trust. If the Family Trust was the contingent beneficiary, upon the disclaimer, the retirement plan or account assets could have been distributed to the Family Trust, thus making those funds available for the surviving spouse despite the disclaimer.
Another example where the beneficiary designation can frustrate your estate plan is in the case where you and your spouse have created an estate plan which upon both of your deaths creates a trust to manage assets for your children until they are 30 years old. However, the beneficiary designation for your retirement plan names your spouse as primary beneficiary and your children as contingent beneficiaries. Assuming the unfortunate event that you and your spouse die in a common disaster, your children are the direct beneficiaries of your retirement plan, not the Trust for their benefit. If your children are minors, the Probate Court will appoint a guardian for the children. Any child over 18 will get his or her share outright without any restrictions. Again, this could have been avoided with the proper beneficiary designation.
When the owner begins to receive distributions from the retirement plan or account, he or she must decide how the distributions are to be calculated. This decision will impact not only the income stream and the income tax for the owner, but may also limit the choices the beneficiaries may have for distributions from the retirement plan or account upon the owner's death. Certain choices may lead to fairly rapid distributions which may increase the beneficiary's tax rate and therefore increase the amount of tax paid, leaving less of the accumulated assets for the beneficiaries' use. With proper planning the beneficiaries may be able to keep a significant amount of money in the retirement plan or account which can continue to grow tax-free, while taking distributions at a lower tax rate.
Many of the seemingly routine decisions regarding retirement plan or account distributions can have a large impact on your estate plan. In many cases if you fail to make a decision, the plan will provide a default decision for you, which may or may not reflect what is best for you or your beneficiaries. It is an essential element of your estate plan to make distribution and beneficiary designations which complement your estate plan. The attorneys who assisted you in creating your will and your trust can assist you in making the correct decisions regarding your retirement plans and accounts. You should consult with them as you make beneficiary designations and prior to receiving your initial distribution from any retirement plan or account.