Meet the Smith family. Mark is the co-owner of a small business with his wife, Margo. The couple has two adult children, Jessica and Larry. Mark also has a sister, Jan, whom he has been financially supporting for several decades. Mark and Margo each have their own retirement accounts. They have contributed to them since their first jobs as teenagers. Each has amassed a large nest egg that they plan to use for their retirement and pass on the remained as an inheritance to their children. Mark has named Margo and Jan as his primary beneficiaries, with 80 percent going to Margo and 20 percent to Jan. Jessica and Larry are secondary beneficiaries. Margo has named Mark as her primary beneficiary and Jessica and Larry as her secondary.
Mark and Margo see their retirement accounts as a way to grow their savings exponentially while taking advantage of the tax savings these accounts provide. In their state, their retirement accounts are protected from creditors’ claims, which gives them additional peace of mind. Mark and Margo are meeting with their estate planning attorney to review their estate plan and ensure they fully understand how the money in their retirement accounts will be distributed upon their deaths.
To make it easier for their beneficiaries to claim their share of the retirement accounts. The Smith’s have provided each beneficiary with the following information:
- The financial institution at which each plan is located
- The contact information for the financial planners at each institution
- A copy of the retirement plan statement
The Smiths know that the financial institution typically will not confirm or deny beneficiary status over the phone. They will verify information such as the beneficiary’s full name, date of birth, address, and social security number. After a beneficiary is confirmed, the financial institution will send a beneficiary claim form.
Most claim forms provide the following options:
- The beneficiary may choose to take a lump-sum payout from the portion of the account to which they are entitled. Using this option requires beneficiaries to pre-plan for taxes, as most qualified retirement plans, except ROTH IRAs, have not been subject to income tax. The financial institution will notify the IRS that the beneficiary has received a check for the amount they are entitled to and has deposited it into their account. The beneficiary will receive a 1099 form from the financial institution at the end of the year to use when reporting their income tax. This payout on which taxes are owed may create a large tax liability or push a beneficiary’s income into a higher tax bracket. Financial institutions may ask beneficiaries whether they would like to withhold a portion of the payout to pay taxes. Financial institutions may also advise on how much money to withhold. If they do not, the beneficiary may seek advice from an income tax professional to determine the appropriate amount.
- The beneficiary may choose to establish an inherited IRA at the same financial institution as the initial account.
- The beneficiary may make a trustee-to-trustee transfer of the plan benefits to another institution. The secondary institution will receive the benefits of an inherited IRA or spousal rollover.
Spouse as a beneficiary
Let’s assume for a minute that Mark passes. Margo, as his spouse, is entitled to 80 percent of his retirement account. She can transfer Mark’s IRA into her IRA. A process called rolling over. If Margo does this, she can use her age as a guide to determine when she must begin taking minimum distributions and how much she must withdraw annually. Since Margo is well below retirement age and has no current need for the money, she may choose to delay withdrawals until she reaches age 72 to take advantage of the opportunity to grow the account in a tax-deferred environment and provide protection from creditors.
Margo can also choose to accept the inherited account as an inherited IRA. An inherited account is not her preferred choice because she does not need the money to support herself. Margo qualifies for this option because she is younger than 59 ½. If she chose this option, she would not be subject to the ten percent early withdrawal penalty assessed if she rolled over the IRA into her IRA and began taking withdrawals. In most states, an inherited IRA does not provide the creditor protection that Margo would get rolling Mark’s IRA into her own. Since Margo owns a small business, she highly values creditor protection. She’ll likely want to consider planning with a Retirement Plan Trust to get back some of the asset protection she wants, and that is otherwise lacking.
Jan is also a beneficiary of Mark’s IRA. She does not fit the definition of an Eligible Designated beneficiary. She is not a surviving spouse, a minor child of the deceased owner, a disabled or chronically ill individual, or any other person who is not more than ten years younger than the deceased account holder. Jan is required to withdraw all retirement plan assets to which she is entitled by December 31 of the tenth anniversary year of Mark’s death. If she does not, she will be subject to a 50 percent penalty for the amount she should have withdrawn by that deadline.
If Jan had been an Eligible Designated beneficiary, she would have qualified for a significantly reduced rate of required minimum distributions. This rate is calculated based on life expectancy.
If Jessica and Larry were under the age of 18, they would not be required to take out any distributions until they reach the age of majority. After which, the ten-year rule would apply, just as it does for non-Eligible Designated Beneficiaries.
Regardless of how distributions are taken, they will be reported on the beneficiary’s tax return as income for that year. All beneficiaries must plan ahead to withhold sufficient funds to pay the taxes or have the financial institution do so.
If you inherit a retirement account, don’t forget to name your own beneficiaries. When no beneficiaries have been named, the process to untangle the owner’s intents can be a significant hassle, and increased tax liability may also result. The IRS treats those who withdraw from retirement plans more favorably than similar trust or estate withdrawals. If no beneficiaries are named, the default is frequently to make the plan proceeds payable to the deceased’s estate. This can be an expensive mistake.
Retirement accounts and other estate planning tools can become very complex. Consult an estate attorney to learn more about the financial, legal, and tax implications of these tools and avoid any potential pitfalls.