Understanding how to manage qualified retirement plans is often a misunderstood area of estate planning. To meet your specific goals, it is important to learn about structuring inheritance for these assets and the tax impact upon your heirs.
What are Qualified Retirement Accounts?
Qualified retirement accounts are employer-sponsored plans that provide tax incentives for people to make investments that can provide financial security when they retire. These accounts can be with a bank or other financial institution, a life insurance company, mutual fund or stockbroker. Common examples include:
- 401(k) plans
- Pension plans
- Profit-Sharing Plans
- SEP IRAs and SIMPLE IRAs
- 403(b) plans
These accounts are "qualified" because they meet specific IRS requirements that allow you to defer taxes (either when you put money in, or when you take it out) and because they are employer-sponsored.
(Note: Traditional and Roths IRAs are not considered a "qualified retirement plan" because they are not employer-sponsored and subject to ERISA rules; but they do offer similar tax advantages, allowing tax-free withdrawals in retirement).
How are Benefits Distributed after Death?
Inheritance in these accounts is generally done through written beneficiary designations submitted to the retirement plan administrator; note that these will supersede any trust or will instructions, because the financial institution must follow the specified beneficiary for each account(s).
Your qualified retirement account cannot be owned by your trust. When you pass away, there should be a beneficiary that you've named on the account who can receive the remaining funds. Normally this will be either your surviving spouse, if applicable, or your surviving children.
There are complex regulations governing qualified retirement accounts upon the owner's demise. Under the SECURE Act, there are three recognized beneficiary classes: eligible designated beneficiaries, designated beneficiaries, and non-designated Beneficiaries. Each class has distinct guidelines, which your estate planning attorney can help you to understand and determine which is best for your situation.
In the case of eligible designated beneficiaries (the most common), the final balance of these accounts are usually some of the first estate assets that are distributed directly upon death to beneficiaries, because they do not go through probate. Categories of such beneficiaries include: the deceased owner's spouse, a child of the deceased owner who is under age 21, an individual suffering from chronic illness, a disabled person, and an individual who is not more than ten years younger than the deceased owner. Each of these subgroups has distinct IRS guidelines in deciding how to manage the inherited account.
How Are Heirs Taxed?
It is crucial to note that qualified accounts don't receive a step-up in basis (which means that the cost basis of the investment is adjusted to its fair market value on the date of your death), whereas a non-qualified account (e.g., brokerage or non-retirement investment account) would receive the benefit of a stepped-up basis under current law.
When you die, any assets in the plan are distributed to your beneficiaries. Different rules apply for surviving spouses and your children (e.g., 10-year distribution rule, rollover options, age-based RMDs, etc.). Another example is the 5-year rule, which generally applies when a non-designated beneficiary (e.g., an estate, charity, or certain trusts) inherits the account, or if the owner died before their required beginning date for RMDs. So talk to your attorney and financial advisor about how to structure these distributions according to your goals.
A critical but often neglected decision in estate planning is the impact of taxes across various asset categories. If the inherited assets are taxed at different rates, those who inherit assets with a higher tax rate will get less value out of the estate (e.g., qualified retirement accounts vs. real estate vs. brokerage accounts). If equal distribution is your objective, make sure to discuss this with your estate planning attorney.
Experts in Estate Planning for Retirement Plans
When it comes to Qualified Retirement Plans, the estate and inheritance laws at the state and federal level can be difficult to understand. At Mortensen & Reinheimer, PC we've helped hundreds of clients structure effective estate plans that encompass retirement plans assets.Let us put our experience to work for you in simplifying what can be a very complex process.
We look forward to helping you! Please contact Mortensen & Reinheimer, PC at (714) 384-6053 to make an appointment, or use our online contact form. Our website is http://www.ocestateplanning.net.
About the author:
Tamsen R. Reinheimer, Attorney, is a Certified Specialist in Estate Planning, Trust & Probate Law (The State Bar of California Board of Legal Specialization). She has significant experience in all aspects of estate planning, trust administration, and probate. Contact Tamsen at tamsen@ocestateplanning.net.