Tax Effects of How You Leave Your Retirement Accounts to Your Beneficiaries

Who you want to receive your retirement accounts in the event of your death is an important consideration in your financial planning. And how you decide to leave the accounts can have significant legal and tax effects.

As explained in Elder Law Answers, a surviving spouse is normally the automatic beneficiary of a 401(k) plan, but not an IRA. This is because 401(k) plans are governed by federal law, the Employee Retirement Income Security Act (ERISA). If you are married and want to leave a 401(k) plan to a beneficiary other than your spouse, your spouse would have to give consent in writing, by signing a waiver.

As pointed out by Mary Randolph, JD, in Nolo, if you leave the retirement account to your estate, the funds in the account will have to go through probate and could be subject to creditors' claims. By designating a specific beneficiary for a retirement account, the beneficiary can continue to take advantage of tax-deferred growth of earnings in the account.

But there may be good reasons not to have your retirement accounts transferred directly to a beneficiary. As indicated by Brenda Watson Newmann in the 401k Help Center, if you have minor children the court may appoint a trustee or guardian to receive the money. And if your children are older, you may have concerns about how they will handle the money. In this case you may want to set up a trust as the beneficiary of your retirement accounts.

Kelly Greene, in an article in The Wall Street Journal, points out conflicting court rulings as to whether inherited retirement accounts are protected from creditors the same way as they were in the hands of the original owner who contributed to the account. This could be another reason to name a trust rather than an individual as a beneficiary.

Natalie Choate explains in Morningstar Advisor that IRS regulations allow a trust to be the beneficiary of a retirement account and still take advantage of income tax deferral by stretching out distributions over the individual beneficiary's life expectancy if the trust meets certain requirements. If the requirements are met, the trust is considered a "see-through trust" and the life expectancy of the oldest child is used as the applicable distribution period.

If the trust is set up for the benefit of one child, this distribution period is not a problem. But if you leave your retirement accounts to a trust for more than one beneficiary, all the beneficiaries must make withdrawals based on the age of the oldest beneficiary. If there is a substantial age difference, the younger beneficiaries would lose the tax advantage of potentially several years of tax-deferred growth of earnings.

When you have more than one beneficiary, you may be able to set up "conduit" trusts for each beneficiary. These trusts would be named as the beneficiaries of your retirement account. If the account is an IRA, each year the required distributions would be taken and separated based on each beneficiary's age. These amounts would go into the individual trusts and would then be paid to the beneficiary. You could set up the trust so that only the minimum amount could be taken out each year.

The trusts would have to be carefully and correctly set up to meet IRS requirements and to achieve your purposes. So it is advisable to consult with an estate planning CPA or attorney.

Sources:

Brenda Watson Newmann, What You Need to Know About Naming a Beneficiary for Your 401k, 401k Help Center

Do Surviving Spouses Have a Right to a 401(k) or an IRA? Elder Law Answers

Kelly Greene, When Trusts Meet Retirement Accounts, The Wall Street Journal

Mary Randolph, JD, Don't Make These Costly Mistakes When Naming Beneficiaries, Nolo Press