Retirement plans (i.e., pension plans, 401(k) plans, employer established IRA plans, etc.) account for the majority of assets held by most Americans. Plans which meet certain legal requirements set forth under the federal ERISA law enjoy favorable tax treatment in order to promote growth and provide a comfortable retirement for the account holder. For example, the account holder is permitted to defer taking any distributions from his/her retirement account until the calendar year in which he/she reaches 70-1/2 years of age, thereby allowing the account to grow tax-free during that interim period. Once the account owner reaches 70-1/2 years of age, he/she is required to begin taking minimum required distributions (MRDs) and those distributions are subject to income tax.
However, the tax advantages of retirement accounts are not intended to benefit the heirs or designated beneficiaries once the account owner has died, with one exception. If the account owner has designated his or her spouse as the beneficiary of the retirement account then, upon the account holder’s death, the surviving spouse can either roll the decedent’s account into his/her own account or remain as the beneficiary of the deceased’s account and postpone taking distributions until the calendar year in which the deceased spouse would have reached age 70-1/2.
Estate planning becomes more complex, however, when the beneficiaries of the retirement plan are persons other than the surviving spouse. In that instance, the beneficiary is required to take MRDs over a period of five years or over the beneficiary’s life expectancy, sometimes referred to as “the stretch period”. If a trust is the designated beneficiary of the deceased’s retirement account and all of the trust’s beneficiaries are individuals, the MRDs are calculated according to the beneficiary with the shortest life expectancy (i.e., the oldest beneficiary).
The entire subject of retirement plans is extremely technical, given the requirements of ERISA and the regulations issued by the Internal Revenue Service. Similarly, incorporating an individual’s retirement plan assets into his or her estate plan can be a complex exercise. Among the issues to be considered are the following:
- How to maximize the stretch period so that the assets in the retirement account can continue their tax-free growth for the maximum length of time;
- Ensuring that the assets are shielded from the beneficiary’s creditors; and,
- Providing a structure for the distribution of the retirement funds (e.g., limiting the disbursements in order to prevent a spendthrift beneficiary from squandering his or her share of the funds in one fell swoop).
We’ll consider these issues in more detail and suggest some planning strategies in upcoming blogs.