Retirement Benefits Overview
If you die with assets in a retirement account, the important issue becomes how the beneficiary will receive payment. Usually, a lump-sum payment is undesirable, because that money is subject to income tax in that year. There is a tax advantage to naming a designated beneficiary. A designated beneficiary must be a natural person (not a trust or charity). Some trusts can be designated beneficiaries if certain conditions are met (e.g., all trust beneficiaries are natural persons). If any beneficiary is not a natural person or eligible trust, all funds in the account must be distributed within five years.
Naming Your Spouse as Beneficiary
With a 401(k) or 403(b) plan, the worker must name his/her spouse as beneficiary unless the spouse signs a waiver. Most pension plans follow the same rule, imposed by federal law. Different laws apply to IRAs and profit-sharing plans—the worker can name anyone as beneficiary. In community property states, the spouse has a legal interest in money the other spouse has earned unless that spouse signs a document giving up the interest.
A spouse-beneficiary can leave the account in the deceased spouse’s name and spread distributions over his/her life expectancy. If death occurs before the worker reached age 70 ½ , the surviving spouse can wait until the year the deceased would have reached that age to begin making withdrawals. A spouse also has the option to roll the plan over to a new IRA in the spouse’s own name.
If you name just one non-spouse as beneficiary, payments can be spread out over the beneficiary’s life expectancy, as determined by the IRS tables. The law also allows a non-spouse beneficiary to transfer the plan assets into a new IRA, as long as the IRA is established in the name of the deceased. Again, payments are made according to the beneficiary’s life expectancy. Assets must be transferred directly from the old account to the custodian of the new IRA.
If you name multiple beneficiaries for one retirement plan, distributions must be based on the life expectancy of the oldest beneficiary. However, the beneficiaries may be able to split the account so that each beneficiary gets a separate share.
Living Trust
Because no probate is needed to transfer funds in a retirement account to the named beneficiary, there is no need to name your living trust as beneficiary in an effort to avoid probate. IRS provisions that give a surviving spouse favorable rights over a deceased spouse’s retirement accounts are not available if a living trust is the beneficiary, even if the surviving spouse is the only primary beneficiary of that trust.
Irrevocable Trust
Occasionally, designating an irrevocable trust to receive what’s left in an IRA at a death can make sense. One can accomplish this by naming the trustee of the trust as the beneficiary. One reason to name the trustee of a trust as retirement account beneficiary is if the beneficiaries are minors and need money managed by a trustee. The same is true if the beneficiary is incapable of managing money. If the trust is properly structured and irrevocable, payments can be received based on the life expectancy of the oldest beneficiary.
Once the trust ends, all funds remaining from the IRA must be distributed to the beneficiary in that year. If your client leaves a retirement account to a child’s trust that ends when the child becomes 25, that is the year of final payout; payments could not be spread over the rest of that child’s life expectancy.
Estate and Income Taxes
The money left retirement plan is subject to federal estate tax. It does not matter how the funds are paid out. If a surviving spouse inherits the retirement benefits, this money is not taxable, because of the unlimited marital deduction. Generally, no income tax is due on inherited money.