This article from Premier Trust discusses how to avoid the common pitfalls to maximizing the value of retirement assets in estate planning.
An executive intends to leave his entire estate to his wife and states so in his will. He forgets, though, that when he filled out the papers for his first job’s 401(k) plan, as a young unmarried man, he named his brother as the beneficiary. When the executive passes away, his brother inherits over $100,000 in appreciated retirement assets instead of his wife.
A high-level corporate executive places her IRA rollover in trust for her three children with the intent that previous spouses and creditors cannot touch their inheritance. However, her attorney fails to meet a four-part test for a “designated beneficiary trust” and the children must withdraw their inheritance over an accelerated five-year period, rather than over their own life expectancies, considerably increasing their tax burden and exposing the assets to the children’s creditors.
These are just a couple of the mistakes people make when leaving tax deferred retirement assets to their heirs. These costly errors can reduce your client’s legacy and prevent their wishes from being carried out. For many people, retirement plan assets make up a significant portion of their total estate, making it particularly important that these assets are not susceptible to creditors.
As of the fourth quarter of 2017, The Investment Company Institute reports that American investors held nearly $29 trillion in tax-deferred retirement accounts. These accounts included $8.9 trillion in IRAs, $7.7 trillion in defined contribution plans, $3.1 trillion in corporate benefit plans, $6 trillion in government defined benefit plans, and $2.2 trillion in annuity reserves.
Retirement assets make up 35% of total assets in the United States, and for many middle- and upper-middle-income investors, the percentage is much higher. “If you are very, very wealthy, retirement assets probably aren’t going to make up a large part of your estate, because there’s a limit to how much you can put into them,” says Bruce Steiner, an estate planning attorney with the New York law firm of Kleinberg, Kaplan, Wolff & Cohen. “If you’re poor, you may not have money to spare to put in, but for middle class people it often is their biggest asset.”
Financial advisors can help their clients maximize the value of these assets by working closely with estate planning attorneys to avoid the common pitfalls listed below.
MISTAKE #1: Not naming beneficiaries
Every time your client enrolls in a company retirement plan or opens an IRA, he or she will be asked to fill out a designated beneficiary form that identifies the person who will inherit that account at the holder’s death. They are often asked for a secondary beneficiary in case the first one has died before the account holder.
It is these beneficiary designations — not the account holder’s will — that determine how retirement assets are distributed. That means that a decision, often made in haste many years before an estate is settled, can determine how a large portion of a person’s assets are transferred.
If a client does not designate a beneficiary at all, the 401(k), IRA or 403(b), assets will typically pass according to the plan document. Most plan documents state that if no beneficiary is designated then the assets will pass to a surviving spouse first. If there is no surviving spouse, many plan documents will designate the estate as the alternative. However, this is not always the case and relying on this assumption can have serious negative consequences.
Brian Simmons, a senior vice president and trust officer with Premier Trust explains, “We had a case where we were settling an estate. The decedent had 3 biological children, 2 from whom he was estranged. He also had a stepdaughter from a marriage later in life. His spouse predeceased him. His will and revocable trust made it clear that he then wanted everything to be split equally between one biological son and his stepdaughter. His wishes were confirmed by his attorney as well as other close friends.
When he died, one of the assets was an IRA account worth $400,000. As its default beneficiary designations, the IRA plan document stated that the assets pass first to spouse, then to children, then to parents, then to estate. The IRA custodian required that the assets be distributed to the 3 biological children and completely cut out the stepdaughter.
The worst part was that both individuals the decedent wanted to benefit were harmed by this. The stepdaughter was cut out completely and his biological son received roughly $66,000 less than he should have.”
On the contrary, if the plan document designates the estate as the alternative, then the assets will be divided according to the terms of the will or trust. “That’s probably fine for most people,” says Steiner, “since the spouse, children or other named beneficiaries will end up getting the retirement assets along with the rest of the estate. However, retirement assets lose protection against creditors when they are included in the estate, so if the owner of the estate owes money, lenders could successfully sue for the contents of his or her retirement accounts. (That wouldn’t be possible if the spouse or children were named beneficiaries.) Also, clients lose the ability to direct assets to beneficiaries who can maximize the value of the retirement account’s tax deferral – younger beneficiaries who can extend mandatory withdrawals over their much-longer life spans. (We’ll talk about this in more detail in “Mistake #3: Losing the stretch.”)
The first thing a financial advisor can do to help clients with retirement assets in estate planning is to make sure that they have named beneficiaries for all their accounts.
MISTAKE #2: Not reviewing beneficiaries regularly
The Bureau of Labor Statistics says that Americans in the baby boom generation (born 1946 to 1964) held an average of 11.9 jobs over their working careers , and younger generations may have even more. That means that by the time your clients retire, they might have a dozen separate 401(k) or other corporate defined benefit plans — all with their own designed beneficiaries — and possibly a handful of individual retirement accounts like Traditional or Roth IRAs. Some of these accounts may have been opened decades ago, perhaps before they got married or had children. Their designated beneficiaries may include people who have died, people they are not close to any more, or people who no longer need their money. They can also neglect those they care about most.
Financial advisors can help their clients with a comprehensive review of retirement accounts and their designated beneficiaries. It may be a good idea to consider consolidating multiple accounts through rollovers to make it easier to oversee investment strategy, performance and risk. It is also important to reduce the number of required minimum distribution calculations and withdrawals once your client reaches the age of 70½.
MISTAKE #3: Losing the stretch
Retirement assets are different from all other parts of an estate in that they have an embedded income tax liability. Taxes are deferred until the account owner or his or her beneficiaries begin withdrawing assets. Regular income taxes are due on the amount withdrawn. As a result, the ability to stretch — or continue to defer withdrawals— from retirement accounts is an important part of estate planning.
If the account owner has already begun mandatory required minimum distributions when he or she dies, then the account owner’s remaining life expectancy governs withdrawals. So, if a woman dies at 75, six years short of average life expectancy, her assets would have to be withdrawn within six years. But if the account owner is under 70 ½ at death, a whole series of options for tax deferral unfolds.
A spouse has the most options when determining how to withdraw retirement assets, since he or she can simply roll the inherited account over into their own tax-deferred investment vehicle and enjoy the same deferral privileges as on their own accounts. That means that spouses under the age of 70 ½ do not need to withdraw assets at all; and those over that age are required to make withdrawals based on their own life expectancy.
However, younger beneficiaries like children and grandchildren can delay withdrawals — and the accompanying tax liabilities — even longer, since withdrawals are based on their own life expectancies. A spouse with a 10-year life expectancy would be required to withdraw 10% of assets per year, while her child with a 40-year life expectancy would only have to take out 2.5%, allowing assets to continue to grow over time. “Stretching out withdrawals,” says Steiner, “is a huge income tax benefit even if it’s an older person with only a 15-year life expectancy. If they must take the money out very quickly, they will bunch the income and it can throw them into a higher bracket. If you can spread it out over some number of years, the bracket may be lower.”
Financial advisors can help their clients by showing them how different beneficiary designations can affect required minimum withdrawals, as well as the tax implications of longer and shorter withdrawal schedules.
MISTAKE #4: Failing to use trusts to protect assets
Advising your clients to designate beneficiaries will ensure the orderly transfer of retirement assets; however additional protections and controls are available when these assets are transferred via trusts. Rick Randall, CEO of the National Network of Estate Planning Attorneys and an estate planning specialist with the Indianapolis law firm Randall Gentry & Pike explains. “Retirement plans are protected from creditors, divorce settlements, instructions for remarriage if someone dies and gets remarried, even from being counted against long-term care expenses during catastrophic illnesses,” he says. “But that protection disappears when the assets are inherited.”
Indeed, in the 2014 case, Clark V. Rameker, the U.S. Supreme Court determined that inherited IRAs were not protected from creditors. The case concerned a woman and her husband who inherited a $450,000 IRA account from her mother in 2001. By 2010, the couple had withdrawn all but $300,000 of the account, and they filed for bankruptcy. They argued that the remaining funds were protected from creditors’ claims, since bankruptcy law exempts retirement funds from the claims. However, the bankruptcy trustee argued, and the court agreed, that the inherited IRA was not protected as retirement funds, since it had not been set aside to meet the inheritor’s retirement needs. The decision was reversed by district court and reversed again by the appellate court and finally settled in Supreme Court, eliminating the protection against creditors.
The Clark decision makes it significantly more important to structure retirement asset bequests via trusts, especially in cases where there may be claims against the spouse, children, or other inheritors.
Trust structures may also make sense when the account owner wants to impose conditions on an inheritance — like holding a job, getting married or having a child — or when he or she is worried about their heir spending the money irresponsibly and wants to limit access to it.
MISTAKE #5: Not qualifying as a designated beneficiary trust
Trusts offer very useful protection against third-party claims, but when carelessly structured, they can shorten the withdrawal period dramatically – to just five years. That can have significant impact on inheritors’ taxes, since income is bunched in a relatively short period, often pushing the beneficiary into a higher tax bracket.
Fortunately, estate planners can get around this problem, while still providing protections against creditors, by structuring a “designated beneficiary trust,” or “look-through trust.” Under this structure, the oldest beneficiary’s lifespan becomes the lifespan of the trust, as long as the trust meets four conditions:
- The trust is valid under state law.
- The trust is irrevocable or will, by its terms, become irrevocable upon the death of the IRA owner.
- The beneficiaries of the trust are identifiable.
- A copy of the trust documents are provided to the IRA custodian by October 31st of the year immediately following the year in which the IRA owner died.
By meeting all these conditions, retirement asset owners can ensure their loved ones get the benefits of continued tax deferral, and all the benefits a trust can provide.
MISTAKE #6: Naming the wrong contingent beneficiaries
Even when clients have successfully created a designated beneficiary trust, some hurdles remain. As stated earlier, the required minimum withdrawal schedule is determined by the oldest beneficiary’s life expectancy. If your client names his wife and two sons, the wife’s life expectancy will determine how fast the assets must be withdrawn. If the client names his children and grandchildren, the oldest child’s remaining life expectancy becomes the standard.
The problem comes when a trust has contingent beneficiaries, especially contingent beneficiaries who are older than the primary ones. For example, say a woman leaves her IRA to her children, and if they die before she does, her grandchildren, and if all of them die and there are no grandchildren, her brother. The brother’s life expectancy, almost surely the shortest of the bunch, will determine how fast the assets must be withdrawn, even though he is unlikely to ever inherit the assets.
Financial advisors and estate planning attorneys can help their clients by reviewing beneficiaries and contingent beneficiaries carefully and highlighting any potential problems.
MISTAKE #7: Not coordinating financial planning and estate planning
Steiner says that it is critical for financial planners and investment advisors to work closely with their clients’ estate planning experts because they are able to spot problems early, while there is still time to fix them. “Financial planners are out on the front lines, and we hope that their eyes are open and attuned to these issues,” he says. “They’re like the primary doctor. If they spot something, then it can be solved. If they don’t spot it then it can’t be solved.”
What to look for? “Financial planners should make sure that there are beneficiary designations in place. They should encourage their clients to coordinate their beneficiary designations with the rest of their plans through their lawyer. “If it’s a $10,000 IRA maybe it’s not worth overhauling your estate plan over it. But if it’s an account of some significance, if somebody’s rolling over a lump sum that they got when they retired from their job, it’s a good time to review your planning and see if it makes sense and coordinate it,” Steiner says.
Rick Randall and his Network have worked to systematize this collaborative process through a proprietary Wealth Reception Planning™ program. “It’s designed to help client families and professional advisors create, appreciate and enjoy true wealth (both financial and non-financial), and to assure true wealth is efficiently transferred and effectively received,” he says.
Shared with permission from Premier Trust 4465 S. JONES BLVD, LAS VEGAS, NV, 89103 TEL: (702) 577-1777 | FAX: (702) 507-0755 Attn: Gino Pascucci
Olson Wealth Group is a full service wealth management firm. With wise counsel and clear strategies, our experienced specialists provide tailored approaches that strive to maximize wealth. For more information, please visit OlsonWealthGroup.com
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