Estate Planning with Retirement Assets

Feb 2020 | Estate Planning & Probate

Since the recession in the late 2000s, many clients have seen a dramatic increase in the value of their retirement accounts – often becoming the largest asset in their estate. Due to the tax-deferred nature of most accounts, ensuring retirement assets are properly considered in a client’s estate plan is essential. While these assets generally pass outside of probate and are not controlled by a client’s Will, clients often incorporate their retirement assets into their estate plan by designating a trust for their spouse or children as beneficiary. Recent changes to the law have complicated and, unfortunately, limited the tax benefits previously associated with retirement accounts.

Basics of Retirement Accounts

In general, retirement accounts, such as a 401(k), 403(b), or Individual Retirement Account (IRA) allow the employee (the “Participant”) to contribute pre-tax dollars to the account prior to reaching a certain age (known as the “Required Beginning Date”). After reaching that age, the Participant must begin taking “required minimum distributions” (“RMDs”) from the account. The RMDs are based on the Participant’s life expectancy as calculated by IRS regulations: the first RMD is comparatively small (when life expectancy is greater), but grows each year. When the Participant passes away, the account is left to his or her designated beneficiaries.

Changes to Inherited Retirement Accounts

Before 2020, after the death of the Participant and regardless of who the beneficiary was, the RMDs were based on the beneficiary’s life expectancy (with some exceptions applicable to spouses that are outside the scope of this blog post). For example, assume Participant X died in 2019 leaving their IRA 50% to Child Y (age 22), and 50% to child Z (age 19). Child Y’s RMDs would be based on a life expectancy of approximately 61 years, and Child Z’s RMDs would be based on a life expectancy of 64 years. This became known as the “Stretch IRA,” because it allowed the beneficiary to stretch the tax benefits over decades.

Unfortunately, the Stretch IRA as we know it has all but disappeared. On January 1, 2020, the Setting Every Community Up for Retirement Enhancement Act (“SECURE Act”) became effective, changing the rules for distributions from retirement accounts left to non-spouse beneficiaries. Now, with narrow exceptions outside the scope of this blog post, all retirement accounts must be fully distributed within ten years of the Participant’s death.

Comparing Old vs. New

To illustrate the impact of the SECURE Act on accounts left to children, revisit Participant X leaving their IRA to Children Y and Z. Assume X dies in 2020 with an IRA worth $1 million. Under the old rules, the RMDs for the first ten years would be as follows – assuming a 6% rate of return:

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The RMDs increase each year, but are relatively small and allow the account to continue growing in a tax-deferred state for many more years or decades. In contrast, the SECURE Act requires that the entire account balance be withdrawn by December 31st of the 10th year following the X’s death. At today’s income tax rates, over $250,000 would be due on the withdrawal.

Planning Strategies

Often, clients leave retirement benefits to a trust for the benefit of their spouse and/or children rather than designating the beneficiaries directly. A common plan involves holding the assets in trust until the beneficiary reaches a certain age while allowing the trustee to make distributions in the interim for specified purposes (such as education, assistance with the purchase of a home, etc.) to avoid children inheriting significant wealth at a young age. The trust can provide control over distributions, protection from creditors, ensure the assets are invested and spent wisely, and allow the trustee to minimize tax exposure due to the SECURE Act’s 10-year payout requirement.

As retirement accounts continue to grow, they often become clients’ largest asset. A comprehensive estate plan involves careful consideration of and planning for retirement accounts. Whether you are in your first job or are near or at retirement age, I recommend consulting with an attorney to discuss these issues. Please contact Steven Matyas and Chad Horner for your estate planning needs.