Where Do Qualified Retirement Accounts Fit Into Your Estate Plan?

Qualified retirement plans offer savers a tax-advantaged way to grow their nest egg and leave a solid financial legacy for their heirs. Naming a spouse or child as the plan’s beneficiary allows you to pass on the assets you’ve accumulated over your lifetime, but doing so has certain tax implications for the recipients. Educating yourself about what the rules are for inherited accounts can make it easier to determine how qualified accounts fit with your estate planning goals.

What are qualified retirement plans?

The range of accounts that fall under the tax-qualified umbrella is fairly broad. The most common types include 401(k) and 403(b) plans, profit-sharing plans, money purchase plans, defined benefit plans and individual retirement arrangements or IRAs, including rollovers from other qualified plans. An IRA may be traditional, meaning income taxes are deferred until you begin making qualified withdrawals, or Roth, which allows for income tax-free growth.

Taxation of qualified plans for participants

The primary benefit of saving for retirement in a qualified plan is your ability to defer paying income tax on earnings until you actually access the money. Once you reach age 59 1/2, you’re able to make withdrawals from your 401(k) or IRA penalty-free but you’ll be responsible for paying taxes on the distribution at your regular rate. (Again, the exception here is the Roth IRA, which is funded using after-tax dollars and requires no additional taxation for qualified withdrawals.)

For all accounts excepting Roth IRAs, you are required to begin taking minimum distributions at age 70 1/2. Failure to do so can result in a 50 percent tax penalty on the amount that should have been withdrawn. Required minimums are calculated based on the value of your account and your life expectancy. If you are married, your spouse’s life expectancy is also factored in to determine the amount you will need to withdraw each year.

Passing qualified retirement accounts to your beneficiaries

When you are forming your estate plan, you should give careful consideration to who will serve as your beneficiaries. For example, if you are setting up a trust, you will have to decide who will inherit your assets after you die and in what amount. Similarly, with a qualified retirement plan, beneficiaries must be named at the time the account is established. You can make changes directly with your investment company over the life of the qualified retirement plan, but the beneficiaries can’t be changed by the terms of a will or living trust.

When you die, any assets in the plan are distributed to your beneficiaries and from that point on, they are responsible for deciding what to do with them. If, for example, you leave your 401(k) to your spouse, they have the option of rolling the assets into an IRA in their own name. Completing a direct rollover allows a surviving spouse to avoid paying a tax penalty at the time the money is transferred and defer paying income taxes on the funds until withdrawals begin. It’s important to note, however, that the minimum required distribution rules still apply. So long as the person who inherits the account is officially named a designated beneficiary, distributions can be spread out over the course of their lifetime.

In situations where your estate or an individual who is not a designated beneficiary inherits a qualified account, the time frame is much shorter. Under the current guidelines, all of the money must be withdrawn within the five years following the plan participant’s death. The primary downsides in this scenario are the loss of future long-term growth on the assets and a higher income tax bill, since the window for taking distributions is smaller. Of course, if the account in question is a Roth IRA, your beneficiaries would not be subject to required distributions or income taxes.

Qualified plans and estate taxes

Aside from impacting your heirs from an income tax standpoint, qualified plans can also affect the amount of estate tax they may owe after you die. This is especially important to understand if an IRA accounts for a substantial percentage of your assets. For 2014, the federal estate tax exemption is capped at $5,340,000 and the top tier tax rate for assets beyond the exemption limit is 40 percent. In Minnesota, the limit for estate tax exemptions is set at $1.2 million, a figure that will climb to $2 million by 2018.

The value of qualified plans is included in the value of your estate for estate tax purposes. If the value of your estate exceeds the exemption limits described above, estate tax can be minimized through family or charitable gifting plan. Assets other than your qualified plan can also be moved to an irrevocable trust to reduce the overall size of your estate.

Developing your estate planning strategy

Writing out a will or setting up a living trust may not be enough to ensure that your heirs are safeguarded financially after you’re gone. There are limits as to what a will or trust can do and their protections typically do not extend to qualified retirement accounts. For example, assuming that you can name someone in your will to receive your IRA is a potentially costly mistake. You would need to name a designated beneficiary to minimize the cost and confusion of inheriting the assets.

If you’ve built up a substantial amount of assets in a qualified retirement account or you have minor children who will be inheriting them, seeking guidance from an estate planning professional is a wise investment of your time and money. The estate and inheritance laws at the state and federal level can be difficult to understand so it is to your benefit to have access to a legal expert who can answer your questions. If you are a Minnesota resident who needs guidance on incorporating qualified retirement accounts into your estate plan, contact knowledgeable estate planning attorney, Jessica Grace today at (612) 326-5291 for assistance.