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What to consider when choosing a retirement account beneficiary
It’s important to think about the tax impact of passing on any retirement accounts to one or more beneficiaries. Unlike some other inherited assets, retirement accounts can trigger an income tax liability to your beneficiaries when they make a withdrawal from the plan.
Your beneficiary may be able to delay, or “stretch out,” taking withdrawals (in turn deferring the income tax) depending on whether:
- You reached your required beginning date for taking lifetime withdrawals at your death
- Your beneficiary qualifies as a designated beneficiary
- Any additional strategies, such as naming a trust as a beneficiary, have been implemented
The distribution options for an individual beneficiary depend on how you’re related. If your beneficiary is your:
- Spouse: They can roll over the inherited plan into their own Individual Retirement Account (IRA), take distributions based on their own required beginning date and name their own beneficiaries — who can potentially stretch the payout of the retirement account over their life expectancies. Or, your spouse can choose to take immediate distributions over his or her life expectancy.
- Children, grandchildren or another individual: They can establish an inherited IRA to hold the inherited retirement accounts. The beneficiary can then stretch out the withdrawals from the inherited IRA by taking minimum withdrawals over his or her life expectancy.
Beneficiaries of an inherited retirement account must also take annual required minimum distributions influenced by whether you reached your required beginning date at your death. If you die before your required beginning date, your plan assets must be distributed within five years of your death unless the benefits are left to a designated beneficiary. A designated beneficiary can withdraw the benefits over the individual’s (or individual trust beneficiary’s) life expectancy.
If you die after your required beginning date, your plan assets must be distributed over your remaining life expectancy (based on IRS tables) or over the designated beneficiary’s life expectancy, whichever is greater.
Naming a trust as your beneficiary
For some people, it may not make sense to name an individual as the beneficiary. In these cases, certain trusts may be considered a designated beneficiary, allowing the withdrawal of the benefits to be based upon the life expectancy of the individual beneficiaries of the trust. These trusts are sometimes referred to as “look through” trusts. The trust must meet the following IRS requirements to qualify:
- The trust must be valid under state law
- The trust must be irrevocable as of the date of the participant’s death
- Certain documentation must be provided to the plan administrator
- The beneficiaries must be identifiable from the trust instrument and must be individuals (e.g. no charities)
If a trust meets these requirements, then withdrawals can be based on the life expectancy of the oldest trust beneficiary, or potentially on the life expectancy of each individual beneficiary.
Simple or complex?
Even though naming an individual as your beneficiary is the simplest and easiest way, sometimes estate planning goals call for using a trust, despite the added complexity. You can still get favorable income tax results by making sure that the trust is structured properly for this purpose. Your estate planning attorney can help you make these decisions and add the proper provisions to the trust.
Examples included herein, if any, are hypothetical and for illustrative purposes only. Individuals should seek advice regarding their specific situation.