Qualified Retirement Plans

Qualified Retirement Plans

For many seniors, their qualified retirement plan is the largest single asset and source of retirement income. It is also the primary asset they pass on to their heirs through their estate plan.

This section covers the features of qualified retirement plans that directly affect estate planning, including when minimum distributions must be taken, how distributions can be taken, and designated, nondesignated and contingency beneficiaries. The section also briefly discusses family limited partnerships, a vehicle for managing an estate that includes a self-employed senior’s business assets.

Qualified retirement plans are widespread today because they receive favorable tax treatment, which promotes saving for the income needs of retired seniors and their spouses. Seniors may have one or more of the following tax-qualified retirement plans:

  • Individual retirement accounts (IRAs) – traditional, spousal, or Roth
  • Employer-sponsored plans such as a 401(k), Roth 401(k) or a 403(b), which are provided for employees of not-for-profit organizations, hospitals, and education
  • Profit-sharing or money-purchase plans

Benefits of Qualified Retirement Plans

Qualified retirement plans enable individuals to defer income taxes on the pre-tax money they put into the retirement plan (not applicable to Roth IRAs or Roth401(k)s that are funded with after-tax contributions) and save as member of a larger investor group, which may result in higher returns on their investments. The benefits of being part of a larger investor group come from having investments managed by financial professionals, as well as receiving matching contributions from an employer, if the plan is employer-sponsored. Individuals can also stretch out the earning power and value of their retirement assets by passing them on to younger beneficiaries.

Minimum Distributions

Once required minimum distributions from qualified retirement plans begin (see following discussion), seniors must take a minimum amount each year. The amount they actually take out is added to all of their other income for income tax purposes. For example, if Dan earns $ 10,000 of income from rental property and he takes $20,000 from his IRA (assuming no other sources of income), his total income for the year would b $30,000 and he would pay income tax based on that amount of income. If he took a lump sum of $100,000 from his IRA, he would pay income tax on $100,000, creating a significant income tax bill. Most persons want to minimize the amount they have to take from their qualified retirement plans to allow for minimum income taxes each year, and to maximize income tax deferred growth. However, they cannot defer taking their distributions forever. These rules applicable to distributions are discussed below.

How Are Minimum Distributions Calculated?

With a few exceptions, plan owners can determine the amount of their required minimum distribution by looking up their age on the Uniform Distribuation Table in IRS REg. 1.401(a)(9)-9, then dividing the balance in the qualified retirement plan by the factor on the table that corresponds to their age. An owner whose spouse is more than ten years younger uses a different table called the Joint Life Table. These tables can be found through the Internal Revenue Service.

Beneficiaries Can Take More than a Minimum Distribution

Notice that the previous discussion assumes that it is beneficial to have a longer life expectancy results in a smaller required minimum distribution from the qualified retirement plan, thus allowing the remaining assets in the plan to continue growing tax-deferred or, in the case of Roth IRA, or Roth 401(k), tax-free.

However, talk of smaller distributions may make some seniors and their beneficiaries nervous. They may worry that they will need larger distributions. You can help alleviate their concerns by reminding them the requirement applies to the minimum that must be taken every year, but there is no limit on the maximum distribution that a beneficiary may take from an inherited qualified retirement plan, even if that beneficiary has not yet reached age 59 ½ (Schnepper, n.d.).

Each type of qualified retirement plan has its own income tax rules. These rules affect how seniors will decide to use the assets in their retirement plan: for retirement income will be paramount. But you should take into account the effects of this decision on your client’s estate planning. Remember, assets in qualified retirement plans are included in an individual’s esate and are taxed after death both under the estate tax and income tax.

When Distributions Can Be Taken

Distributions or withdrawals without penalty from qualified retirement plans:

  • May being at age 59 ½;
  • Are required after the plan owner’s death;
  • Must start by the plan owner’s required beginning date-by April 1 of the year following the year the owner turns age 70 ½.

Distributions May Start at Age 59 ½

Individuals may start taking distributions without penalties from their retirement plans as early as age 59 ½. But, as, discussed below, if individuals withdraw funds prior to this age, they must pay a 10 percent penalty, plus ordinary income tax on the amount withdrawn (expect for after-tax Roth IRA and Roth 401(k) distributions).

Distributions Must Start by Age 70 ½, the Required Beginning Date

Seniors must begin taking yearly minimum distributions from their qualified retirement plans by their required beginning date (RBD) or face a 50 percent penalty tax on the amount that should have been taken. The required beginning date is determined by the age of the plan owner. It is always April 1 of the year following the year in which the senior reaches age 70 ½. No distributions are required from Roth IRAs or Roth 401(k)s at age 70 ½.

It is easier to calculate the required beginning date if you remember that seniors fall into two categories, depending on their birth dates:

  • Category 1: Seniors whose birthday falls between January 1 and June 30. Their required beginning date is April 1 of the same year in why they turn 71.

For example: Vivian has a 401(k) from her former employer. Vivian was born on March 4, 1939. Vivian celebrates her 70th birthday on March 4, 2009. Vivian will celebrate her half birthday, turning 70 ½, on September 4, 2009. Therefore, Vivian’s required beginning date is April 1, 2010.

  • Category 2: Seniors whose birthday falls between July 1 and December 31. Because they turn 70 in the later half of the year, they won’t turn 70 ½ until the next calendar year, the year they also turn 71. Therefore, their required beginning date is not until April 1 of the year in which they turn 72.

Example: Jim has an IRA from which he has not taken any distributions. Jim’s birth date is August 16, 1940. Jim turns 70 in 2010, but won’t turn 70 ½ until 2011. Therefore, Jim’s required beginning date is April 1, 2012.

Seniors who are working and contributing to an employer-sponsored plan can delay taking distributions from this plan until they retire. However, they must begin taking distributions on their normal required beginning date from any IRA they own outside the company plan.

How to Determine the Required Beginning Date

If You Were Born:

Your Required Beginning Date Is:

Between January 1 and June 30

April 1 of the same year you turn age 71

Between July 1 and December 31

April 1 of the same year you turn age 72*

 

*Because the required beginning date is always April1 of the year following the year in which you turn age 70 ½

 

Designated Beneficiaries

There is significance to the type of beneficiary named for a qualified retirement account. A designated beneficiary receives special treatment. (Designated beneficiaries are discussed below.) Note that the following examples of distributions assume that the beneficiary qualifies for treatment as a designated beneficiary under the tax rules.

Distributions after Death

What matters most in distributions from qualified plans after death is whether the senior died before or after the plan’s required beginning date. This determines the form in which distributions can be paid out (lump sum, rollover, or minimum distributions based on certain life expectancies); how quickly the plans must be paid out; and the tax liability for the beneficiaries. Concerning tax liability, except for Roth IRAs, distributions from qualified retirement plans are subject to income taxes, and distributions from qualified retirement plans are subject to income taxes, and distributions from qualified retirement plans are added to the beneficiary’s taxable estate, as are any other assets inherited by the beneficiary.

When Death Occurs before the Required Beginning Date

If a senior dies before the required beginning date, his or her qualified retirement plan can be paid out to the designated beneficiaries in one of three ways:

  • As a lump sum by December 31 of the first year after the owner’s death
  • Rolled over into an IRA owned by the decedent’s spouse who is also the plan’s designated beneficiary (an option available only to a legal spouse, not to unmarried heterosexual, gay, or lesbian partners)
  • Paid out to the designated beneficiary (Surviving spouse or other individuals) over the beneficiary’s life expectancy in yearly minimum distributions starting no later than December 31 of the first year after the plan owner’s death

For example: Laura names her only child Matthew as her IRA beneficiary. When Laura dies at age 69, Matthew, age 41, can take a lump sum payment or choose to take yearly minimum distributions based on his life expectancy. If Matthew chooses a lump sum payment, he will have to pay corresponding income taxes and will no longer have retirement assets growing tax-deferred. For example, fi the lump sum is $70,000 and Matthew earned $30,000 of other income during that same year, he would be taxed on $100,000 of income at the corresponding (and higher) brackets. However, if Matthew chooses minimum distributions over his life expectancy, he will pay less each year in income taxes, which could help his cash flow as well as build a retirement fund that continues growing tax-deferred.

When Death Occurs after the Required Beginning Date

If a senior dies after the required beginning date, his or her qualified retirement plans can be paid out to the designated beneficiaries in the same three ways as when death occurs before the required beginning date-with a variation on the third option:

  • As a lump sum by December 31 of the first year after the owner’s death
  • Rolled over into an IRA owned by the decedent’s spouse who is also the plan’s designated beneficiary (remember, legal spouses only)
  • Paid out to the plan’s designated beneficiary (surviving spouse or other individuals) in yearly minimum distributions over either the:
    • Beneficiary’s life expectancy starting no later than December 21 of the first year after the plan owner’s death; or
    • Decedent’s actuarial life expectancy; using the appropriate actuarial tables (The Motley Fool, n.d.)

For example: Luke names his wife Muriel as the beneficiary of his IRA. When Luke dies at age 75, Muriel is 68. If Muriel takes a lump sum distribution, she pays income taxes on the entire amount and the size of her taxable estate is increased. However, Muriel can also roll over Luke’s IRA assets into her own IRA or she can choose minimum distributions from Luke’s IRA using her own life expectancy or Luke’s actuarial life expectancy.

If Muriel chooses to take minimum distributions from Luke’s IRA and uses her own life expectancy,because she is younger than Luke, the assets in Luke’s IRA will keep growing tax-deferred for a longer time. But, if Muriel rolls Luke’s IRA into her IRA, she can take even smaller minimum distributions, and her increased IRA assets also grow tax-deferred for a longer time.

There are two important implications for Muriel and her beneficiaries:

  • income taxes-she pays less income tax each year on minimum distributions than she would pay all at once on a lump sum, which could help her cash flow
  • estate planning-if Muriel rolls Luke’s IRA into her own IRA, she may have more assets to leave to her beneficiaries after she dies, and she can also stretch out her IRA assets (see next section) for as long as possible by naming young beneficiaries such as her nieces and nephews.

Stretch-Out IRAs

The longer money remains in an IRA, even after an owner’s death, the longer it can grown tax-deferred. Naming a beneficiary to keep money in an IRA for as long as possible after the owner’s death is referred to as creating a stretch-out IRA (Schnepper, n.d.; Merrill Lynch, 2003). Seniors can create a stretch-out IRA using an IRA they already own or by instructing that, at their death, their assets from another qualified retirement plan be rolled over into an IRA.

Before- and After-Death Distributions from Roth IRAs

Use of Roth IRs and Roth 401(k)s can be an excellent way to stretch out retirement assets and pass them on to heirs free of income taxes. Because Rothaccounts are funded with after-tax dollars, once a person has kept a Rothaccount for the required five-year holding period, he or she can take distributions from it. The distributions are not subject to income tax as long as the 59 ½ age requirement is met.

Once a Roth owner dies, the minimum distribution rules that apply to traditional IRAs apply to Roths, as though the Roth owner died before his or her required beginning date. The exception is that Roth distributions to the decedent’s estate or beneficiaries are not subject to income tax. For this reason, Roths can stretch out retirement assets and pass them on for generations. (Rothaccounts are still considered part of the decedent’s and beneficary’s estates for estate tax purposes, just like a traditional IRA.)

The Importance of Naming Beneficiaries

A qualified retirement plan is a unique and potentially large asset. Many people assume that leaving it as an inheritance to others is a simple matter, but it is not. It is one of the most important decisions in estate planning because there are complex tax consequences for the giver’s estate and the beneficiaries. Making an uninformed beneficiary selection can:

  • generate significant income and estate taxes for the beneficiaries;
  • leave loved ones with reduced benefits;
  • reduce the long-term value of the retirement account for the beneficiaries.

The identity of the beneficiary determines how quickly minimum distributions must be paid out, in what amount, and how they are taxed.

Who Can Be a Designated Beneficiary?

The designated beneficiary of a qualified retirement plan must be an individual or definable group of individuals, or a trust with an individual or group of individuals named as the beneficiary. A designated beneficiary cannot be a company or institution such as a charitable organization. (Individuals can still leave their plan assets to a charity as a nondesignated beneficiary.)

If a plan owner dies before the required beginning date, regardless of how young or old a beneficiary is, his or her life expectancy must be used to determine the minimum distribution. If death occurred after the required beginning date, the beneficiary may choose to use their own life expectancy or the actuarial life expectancy of the owner.

Choosing which life expectancy to use in calculating the amount of the minimum distribution is a very important decision. As we’ve already seen, the younger the beneficiary, the longer the retirement assets can grown tax-deferred in a traditional IRA or tax-free in a Roth IRA.

Group Beneficiaries

When the designated beneficiary is a group of individuals, there are several options for selecting the life expectancy that will be used to determine the minimum amount that will be distributed to each member of the group.

Beneficiaries can use the age of the oldest in the group. The following example explains this option: Tomas fills out the beneficiary form for his IRA, naming his surviving children equally. When Tomas dies at age 78, he is survived by all three of his children, ages 58, 55, and 51. The yearly minimum distributions from his IRA will be determined based on the life expectancy of the child who is age 58.

They can also use the actuarial life expectancy of the plan owner when the owner died after the required beginning date, or they can create subaccounts that allow each person in the group to use his or her own life expectancy. For example:

Leanna names all three of her children as the beneficiaries of her IRA. When Leanna dies at age 80, her children are 57, 53, and 50. They can keep the IRA in one account and take minimum distributions based on the life expectancy of the oldest, who is age 57. Or they can keep the IRA in one account and take minimum distributions based on Leanna’s actuarial life expectancy (because Leanna died after her required beginning date) or split the IRA into three separate subaccounts, one for each child. Then the children can take minimum distributions from their individual subaccounts based on their own life expectancies. (The use of separate subaccounts can be done either before the participant’s deathor by September 30 of the year following the participant’s death. Subaccounts can be used whether the owner died before or after the required beginning date.)

Note that there are specialized rules to qualify for subaccount status. This technique must be put in place by a professional who thoroughly understands the current IRS rules relating to the creation of subaccounts.

A Trust as Beneficiary

Trusts themselves do not have life expectancies. However, a trust can be a designated beneficiary of a qualified retirement plan if it meets certain legal requirements. The trust must be:

  • valid under state law;
  • irrevocable;
  • established for the benefit of identifiable individuals who will clearly receive the distributions from the decedent’s qualified retirement plan.

Note that there are specialized rules that apply to naming a trust as a designated beneficiary. This technique must be put in place by a professional who thoroughly understands the current IRS rules relating to the qualification of a trust as a designated beneficiary.

A Charity as Beneficiary

Charities can be beneficiaries of qualified retirement plans. A charity that qualifies for tax-exempt status may receive a lump sum and pay no income taxes on the distribution, no matter how large the distribution is. Not that if both charities and designated beneficiaries are named, special estate planning techniques must be used to ensure the designated beneficiaries can exercise all their payout options. For example:

Bill died at age 79 witha large IRA. He named his church as a beneficiary of 10 percent of the IRA and left the remaining 90 percent to his daughter Elizabeth. The church is not a designated beneficiary, so Elizabeth cannot take minimum distributions based on her life expectancy. Instead, she must use bIll’s actuarial life expectancy.

In the example above, separate subaccounts could have beenused to distribute assets from a retirement plan (Raymond, 2000). If the charity takes its 10 percent of Bill’s IRA and puts it into a separate account and Elizabethdoes the same withher portion of the IRA prior to September 30 of the first year after Bill’s death, then Elizabethwill be the only remaining beneficiary. Because she qualifies as a designated beneficiary, she can then take minimum distributions based on her own life expectancy, if she choose. The benefit to Elizabeth is that her minimum distributions will be smaller than they would have been using Bill’s actuarial life expectancy, and the remaining funds in her subaccount can continue to grow tax-deferred.

Note: If Bill had died before his required beginning date, then it would not have been an option to use his actuarial life expectancy to calculate the minimum distributions. In that case, the use of subaccounts would also work as a solution to allow Elizabeth to use her own life expectancy, which would still reduce her minimum distribution each year.

Naming Contingent Beneficiaries

Seniors should name at least one contingent beneficiary of their qualified retirement plans. In that case, if their primary beneficiary dies, the tax-free growth of the IRAs is still available to someone else (assuming there are assets remaining in the IRA), and the IRA can be stretched out to a younger beneficiary with a longer life expectancy.

Naming a contingent beneficiary also allows the individual, as the original owner of the retirement plan, to pass on the flexibility of some after0death maneuvering to his or her heirs. The owners of retirement plans can use disclaimers to create tax advantages for themselves (see the section “The Inheritor’s Disclaimer,” ). For example:

Mark names his wife Linda as the primary beneficiary of his IRA and their son Adam as the contingent beneficiary. At Mark’s death, Linda’s advisorspoint out that Linda has sufficient resources that she will likely never need to access Mrk’s IRA. Also, if Linda inherits Mark’s IRA, while there will be no estate taxes on it (because it passes to Linda under the unlimited marital deduction), the IRA would end up being in Linda’s estate and could create a higher estate tax burden for her upon her death.

Therefore, Linda decides that she would rather let Adam inherit Mark’s IRA. By disclaiming the IRA, Linda allows the IRA to pass to Adam, who will be able to take minimum distributions from the IRA based on his life expectancy, which is longer than Linda’s.

This completes the discussion of the key features of qualified retirement plans that affect a large number of middle-income seniors and the success of their estate planning. In addition to qualified retirement plans, many seniors own their own business, so you should be aware of family limited partnerships, a vehicle for managing estates that specifically addresses the estate planning needs of business owners.

The information above is reprinted from Working with Seniors: Health, Financial and Social Issues with permission from Society of Certified Senior Advisors® . Copyright © 2009. All rights reserved. www.csa.us