Are Your Retirement Plan and Estate Plan Working Together?

The Baby Boomer generation is the first in American history to hold a sizeable proportion of their wealth in retirement plan accounts. The 1960s-era law that allows workers to divert a portion of their earnings to tax-advantaged accounts has been a rousing success. In fact, it has become commonplace for retirees to hold the bulk of their wealth in retirement plan accounts. That trend is likely to continue as concerns about the stability of the social security system and popularity of new and improved retirement plans motivate people to pump more and more money into their retirement accounts. While tax-advantaged retirement plans might be a great way to save for retirement, it is not always easy to transfer that wealth and the associated tax advantages to the next generation through traditional estate planning techniques. Because of the special nature of retirement plan accounts, they present challenges to those trying to integrate their retirement plans into their estate plans. They also present a few opportunities.

Stretch IRAs

The income tax benefits of retirement accounts are pretty well known and widely touted by retirement plan providers and financial planners. If structured properly, beneficiaries of your retirement account could take small annual withdrawals over their life expectancies after you have passed away. Any funds not withdrawn from the account could continue to grow tax-deferred. That should result in increased wealth to your beneficiaries.

But what if your beneficiaries, say your children or grandchildren, are too young to handle the money? Do you really want to leave a $1 million Individual Retirement Account (IRA) to your 20-year-old son? Is it realistic that your 23-year-old daughter will only withdraw the minimum distribution amount from the retirement account each year? What if your daughter is a spendthrift, or your son's marriage is on the rocks? In these situations most estate planners would recommend the use of a trust, so that someone other than your child would control the funds until the child is mature and stable enough to handle the money. But only certain kinds of trusts can take advantage of the continued income tax deferral available through retirement accounts. If you name an improperly drafted trust as a beneficiary of your retirement account, you may only get a few years of continued tax deferral, as compared to the possibility of several decades of tax deferral through a properly drafted trust.

Second Marriages

Surviving spouses are offered special benefits that are not available to other beneficiaries under the retirement account distribution rules. To take advantage of those benefits, however, you need to leave your retirement account to your spouse with no strings attached. That might not work well if your goal is to make sure the remaining account balance eventually passes to children from a previous marriage. Again, you could use a trust for this purpose. But it is difficult to both accumulate the retirement account benefits for later distribution to your children and also defer income taxes within the account for any significant period. In some cases it might make more sense to leave your retirement account directly to your spouse and buy a life insurance policy for your kids. Or leave the IRA to your kids and buy a life insurance policy for your spouse. You could also divide the IRA between your kids and spouse, if other resources are available for your spouse.

Charitable Giving

If you want to leave something to charity, it might be most efficient to satisfy charitable bequests with distributions from your retirement account after you have passed away. The charities would not have to pay income tax on the funds they receive from your retirement accounts, whereas your spouse, children or grandchildren would. But make sure that your beneficiaries do not dawdle. A charity's portion of your retirement account must be paid, or at least segregated, in a separate account by September 30 of the year after you pass away. Otherwise, your other non-charitable beneficiaries might lose some of their ability to defer income taxes on the portion of the retirement accounts that pass to them.

As retirement account balances grow, so too grows their importance in estate planning. Because the rules relating to retirement accounts are complex, special attention and drafting are needed during the estate planning process. The Internal Revenue Service rules governing post-death distribution from retirement accounts were substantially re-written in 2000. If your estate planning documents have not been updated since 2000, they probably do not include the particular language that lawyers use today to address retirement accounts. Also, if your retirement accounts have grown, either in absolute terms or as a proportion of your total wealth, it might be prudent to call your lawyer to determine whether your estate planning documents should provide for the distribution of your retirement accounts as a part of this written plan.

Kevin Alerding is a partner in Ice Miller's Personal Services, Trusts and Estates Group. His practice focuses on estate planning, business succession planning, estate and trust administration, and litigation involving estates and trusts.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.