Ways to Reduce or Avoid Paying Death Tax on Retirement Funds


Most middle-class Americans’ intangible wealth is held in qualifying retirement benefits, individual retirement accounts (IRAs), and life insurance payouts, according to Louis Mezzulo’s An Estate Planner’s Guide to Qualifying Retirement Plan Benefits. Income and capital gains tax advantages have contributed to the massive growth of IRAs, 401(k)s, and other retirement plans. While most people don’t consider what will happen to these accounts when their owner dies, they provide strong tax incentives to save money throughout one’s lifetime. The truth is that these accounts can be hit with estate and income taxes when their owners pass away. However, with intelligent planning, you can reduce or avoid estate taxes on retirement funds upon passing. Several factors to consider when deciding who should benefit from a plan are discussed here.

Choosing Between Old and Young Recipients

Beneficiaries of retirement plans are rarely selected with age in mind. However, after accounting for taxes and required minimum payments, the amount of money a recipient receives could vary depending on their age. To illustrate, suppose that in 2012, John Smith passed his $1,000,000 IRA to his son Robert Smith, who is 50 years old. The IRA will have a final balance of $117,259 in 2046, assuming 8% growth, current tax rates, and continued RMDs. Rober will be 84 years old, then.

Let’s change tack and imagine that John Smith passed the IRA on to his grandchild Sammy Smith in 2012. The IRA will increase to $6,099,164 by 2051 if the same 8% rate of growth is applied and, if required, minimum distributions are made. Sammy will have reached the age of 54 by then. Which one sounds better to you? Would you instead leave your $1,000,000 IRA to your grandchild and have it grow tax-free into nearly $6,000,000 over the following few decades, or would you rather go it to your child and grow tax-free into $500,000?

The sums in the previous paragraph are correct, by the way. Since a grandchild’s RMDs are much lower than those of an older adult, the grandchild’s IRA account grows far faster in their hands. Having an elderly adult, such as a parent or grandmother, as a retirement plan beneficiary is the worst-case scenario regarding required minimum distributions. Withdrawing the entire plan’s value could take several years if this happens. This would lead to a high-income tax and negligible tax-deferred growth potential.

Donation Designation

At death, many people hope to help the causes they care about. There are several valid reasons to leave a portion of one’s estate to charity, such as a sincere wish to aid the organization, a desire to reduce one’s taxable estate or the absence of other heirs. In most cases, an estate can reduce its taxable value by the amount left to charity after death. As a result, the federal government may have less opportunity to collect taxes from the estate. However, with the estate tax exemption of nearly $5,000,000 in 2018, very few people will have to worry about paying this tax.

However, by leaving the retirement plan to a charity, the individual may be eligible for a discount on both the inheritance and income taxes that the retirement account’s beneficiaries will owe. A beneficiary who is a tax-exempt charity might potentially cash out their whole retirement plan and avoid paying taxes. This approach is similar to “having your cake and eating it too”: The recipient does not have to pay income tax on the plan’s distribution because both the employee and the employee’s beneficiary have avoided capital gains taxes on the account over their lifetimes. That’s some intelligent financial preparation!

As was said before, designating a charity as the beneficiary of a retirement plan requires a sincere desire to help others. The naming of the strategy should also be in sync with the larger scheme of things. Is it the case that the retirement plan’s beneficiary designation only includes individuals, but the present revocable trust leaves a sizable sum to charity? Switching the retirement plan beneficiaries and the confidence in this situation could make sense. As a result, the beneficiary’s tax bill would be reduced to a minimum upon the plan participant’s passing.

Using a Trust as a Designated Recipient

People should exercise great caution before designating a trust as the recipient of their retirement funds. Whether drafted by an attorney or purchased as a do-it-yourself kit, retirement plan distribution provisions are typically lacking in revocable living trusts. Acceleration of distributions from the plan at death may occur if a living trust does not include “conduit” provisions that allow distributions to be channeled out to beneficiaries. Therefore, beneficiaries’ income tax obligations could balloon. In some instances, the retirement plan can be made payable to a revocable living trust with conduit provisions. The trust’s beneficiaries would automatically become the retirement plan’s ultimate beneficiaries. Furthermore, if the trust is well-drafted, dividends can be spread across the beneficiaries’ lifetimes.

A “standalone retirement trust” (SRT) may be preferable to appointing a revocable living trust as the retirement plan’s beneficiary. A properly formed SRT, like a revocable living trust with conduit provisions, allows payouts to be spread out over the lifespan of beneficiaries. The SRT can also be set up as an accumulation trust, which allows distributions to be held in trust for the benefit of beneficiaries. Having a third-party trustee available can be a huge benefit when a beneficiary cannot handle their trust assets. For instance, if the account’s beneficiaries are minors, a trustee or custodian may be necessary to prevent a guardianship proceeding. Using a trust to hold onto plan benefits provides the same divorce, creditor, and asset protections that younger beneficiaries enjoy.

The trustee, rather than the beneficiaries, can extend plan benefits beyond the beneficiary’s lifetime, which may be the most significant benefit of an SRT. This makes it less likely that a beneficiary will “blow it” by demanding a lump sum distribution and using the money to buy a Ferrari. Eventually, the trust might name one of the beneficiaries as the only co-trustee. Thus, these trusts can serve as a valuable method for reducing tax liability and fostering a sense of accountability in the beneficiaries.

Incorrect Recipients

The unintended consequences of naming a beneficiary are real. For instance, if the value of the plan and other probate assets exceeds $150,000, the program will need to go through probate in California if the “estate” is named as the beneficiary. Furthermore, designating the trust as the beneficiary could hasten disbursements if the trust is not drafted correctly. Finally, setting an older heir may hasten withdrawals from the plan, reducing the estate’s potential tax savings. Reviewing beneficiary designations regularly and consulting with an experienced estate planning attorney can help individuals avoid these issues.

Beneficiary Designations vs. a Will or Trust: A Reminder

You may be asking yourself, “Wait a minute, couldn’t I just rely on my will or trust to deal with my retirement plans?” if you’ve made it this far in the article. This is a terrible idea. You should know that your will or trust will not control who receives retirement plan benefits; instead, the beneficiary designation you make. For instance, a retirement account will be distributed to the individuals specified in the beneficiary designation rather than the charity named in the trust or bequest. For some people, this could mean their projected estate tax charitable deduction is less significant than initially thought.

It’s Worth It to Pay Attention; Final Thoughts.

Beneficiary designations for a retirement plan can seem easy at first glance. After all, it’s not hard to complete the form’s minimum requirements. However, if you don’t pick the “right” beneficiary, you could end yourself paying more in taxes, going through probate, or even having your estate plan defeated. If you need help completing a beneficiary designation form, consult a trusts and estates attorney. Our Menlo Park living trusts attorneys regularly do beneficiary designations, and we’d be pleased to help you or properly lead you if you have any questions.

Legacy planning, wealth preservation, estate and business succession planning, and estate administration are our law company’s sole areas of practice. Our office is in Menlo Park, California, and we serve clients around Silicon Valley and the Bay Area.

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