McClellan Legal LLC Estate Planning & Tax Assessment Blog

Monday, February 25, 2019

Inheriting Retirement Assets is Tricky Business

For most people, a very large amount of their wealth is associated with their retirement accounts including traditional IRAs, Roth IRAs, 401ks, etc.  However, retirement assets are often overlooked during the estate planning process.  Do you have retirement assets that would result in a payout of over $100,000 per beneficiary?  If so, you must keep reading.  Even if you do not currently have a large retirement account, this article provides some solutions to common mistakes regarding inheriting retirement assets.  Ignoring retirement assets is the single biggest mistake that I've seen in estate planning.

One of the most common goals of my estate planning clients is to minimize the tax burden on their estate.  As you may recall, the federal government does not tax an estate unless it is over the federal exception amount, currently $11.4 million.  Therefore, a very small number of estate (about 1800 estates/year) are subject to the federal government’s 40% estate tax.  However, your beneficiaries may pay nearly 40% of your estate to the federal government via income tax if you do not properly plan for the distribution of retirement assets to your beneficiaries. 

When you leave a retirement account to a beneficiary, the beneficiary of the retirement account usually implements one of the following withdrawal options:

  1. Immediately withdrawing the full amount of assets (bad idea),
  2. Withdrawing the assets over a short period of time (not a great idea), or
  3. Stretching-out withdrawals based on life expectancy (great planning).

An immediate withdrawal of the assets is all too often the withdrawal decision made by beneficiaries.  In nearly every situation, this will generate a very poor result.  Usually the beneficiary simply does not understand the tax implications of what they are doing.  First your beneficiary will be faced with ordinary income tax on the entire amount withdrawn from the retirement accounts, likely at the maximum income tax rate (currently 37%).  In effect, that's a nearly 40% hidden tax on your estate. Proper planning can greatly reduce the tax burden.  Further, an immediate withdrawal reduces the tax-deferred growth of the retirement account over the expected life of the beneficiary.  For example, a $300,000 inherited IRA can result in an $180,000 inheritance to your child if the asset is immediately withdrawn.  If properly planned, that same $300,000 inherited IRA can grow to a value over $3 million. 

A strategy that withdraws the assets over several years will likely reduce some of the tax burden when compared to the full withdrawal strategy but is certainly not the best idea.  The optimal withdrawal strategy that stretches-out the withdrawals over the expected life of the beneficiary will minimize the tax burden and maximize the tax-free growth of the inherited retirement account.

There are several planning solutions to help you achieve a very good result:

  • First you must check your beneficiary designations to ensure that the retirement accounts will not go to your "estate".  Such a result would eliminate the ability to stretch-out the withdrawals over the beneficiary’s life because the "estate" does not have a life expectancy.
  • Even if your beneficiary designations are well planned, you will need to educate your beneficiaries on the importance of stretching-out retirement accounts.
  • You will need to ensure that your estate has enough liquid assets to pay any debt or tax obligations without forcing your estate to use retirement assets.
  •  Finally, you may want to consider leaving retirement assets to your grandchildren, in order to extend the tax-deferred growth over their longer life expectancy. 

For people with large retirement accounts, we can prepare a Stand-alone IRA Trust to ensure that retirement assets are handled properly by your beneficiaries in order to minimize taxes, maximize growth and build your legacy. If you have any concerns regarding planning for retirement accounts, please contact our office to schedule a meeting.

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