Estate Planning Around Your Nest Egg
When you think of “estate planning,” you probably imagine writing a will and giving instructions about who gets the house, the car and grandma’s jewelry. But, an important asset for many people is their IRA and employer retirement plan. Retirement plans are generally passed to beneficiaries directly, and are not disposed of in a will. Talk to your lawyer about estate planning around your nest egg. It should coordinate with your overall estate plan and with your will or trust.
A traditional IRA is a retirement plan for individual investors. You can open one if the funds you contribute come from taxable earned compensation made during the year of the contribution. The advantages of IRAs is that your contributions are not taxed at the time you invest or annually. It is only taxed at the time of withdrawal. At that point, you will pay income tax on whatever you withdraw, but presumably at a lower rate because your income will be less at retirement. These rules mean that you invest every cent of what you put into the IRA, which can add up to a lot of money over 30 years.
You must start making withdrawals after you reach age 70-1/2. The amount you must withdraw each year depends on your age. It is calculated so that you will use up your retirement income by the time you die.
You can name someone as the beneficiary of the account on the beneficiary designation form the account custodian gives you when you open an IRA. The beneficiary will inherit the balance of the account on your death. You do not need to mention the IRA in your will or living trust—the beneficiary form is the only thing you’ll need to sign. And don’t worry, you can change your beneficiary at any time. It’s your money after all.
When the beneficiary receives the funds, he or she has several options. If your spouse is the beneficiary, your spouse may roll over your retirement plan into his or her own IRA. No other beneficiary has this option, not even your children.
All beneficiaries have the option of withdrawing the money from the IRA immediately. Although if they do this, they will have to pay income tax on the money they receive. With careful planning, however, your beneficiary may be able to spread distributions out over many years.
It’s important to remember that your IRA passes to beneficiaries outside your will. It does not go through probate. However, it is not an ideal vehicle if your primary aim is to pass money to beneficiaries. This is because the compulsory withdrawal of funds means that the money will be depleted at your death, unless you die earlier than the actuarial tables suggest. If you want to build up your estate, pass money to beneficiaries, and avoid probate, a better option is the Roth IRA.
Roth IRAs do not offer a tax deduction for contributions. However, they do provide tax-free withdrawals. In addition, they do not mandate compulsory withdrawals after you turn 70-1/2. For these reasons, Roth IRAs are an appropriate vehicle for people who want to build their estate and avoid probate after death.
You can contribute up to $6,000 per year to a Roth IRA ($7,000 if you are over 50) and let the income accumulate, tax-free. After your death, the money will go to whomever you named as the beneficiary. The beneficiary will simply need to show a certified copy of the death certificate to claim the funds.
Employer Retirement Plans
Most people get retirement benefits from an employer. One popular option is a 401(k) plan. A 401(k) plan allows you to defer part of your salary into a retirement fund. This way, you can save for retirement while simultaneously reducing your income tax.
Typically, an employer retirement plan will pay benefits to beneficiaries when you die. However, there are all kinds of rules that may attach to employee retirement funds. Rules may include stipulations that benefits be paid to beneficiaries in the form of a survivor annuity. A lump sum distribution may only be available if you file a waiver before you die.
In most cases, the law requires that your spouse gets a portion of these retirement benefits. Your spouse may roll the money over into his or her own retirement plan. Your spouse may also waive the right to receive a portion of your retirement benefits only by giving a properly witnessed, signed consent.
Why would your spouse waive the right? There are several possible reasons. Your spouse might not wish to pay income tax on the distributions from the plan. Or, perhaps, the money might be better used by another beneficiary. If your spouse does waive the right, then your plan should allow you to name some other beneficiary, such as a child or a trust.
Be Clear About Your Beneficiaries
It might seem pretty easy to nominate beneficiaries to these retirement vehicles, but life has a way of making things difficult. Remember, the bank or plan will do what the form tells them to do. So, it’s up to you to make sure that the form reflects your current intentions. For example, if you get divorced, you’ve got to remember to update your IRA beneficiary form, so that your ex-spouse is no longer listed as beneficiary.
Or what if you have complicated wishes? Say you want to leave your IRA account to your son and daughter, with the intention that your daughter’s children share any money left over when your daughter dies? Forms offered by banks and brokers may not offer this option. If your bank or broker allows it, you should attach an additional beneficiary designation to the printed form provided. In this document, you can provide more detailed distribution planning. However, banks and retirement funds aren’t in the business of settling your estate. And, there are limits to what you can ask them to do through beneficiary designations.
Naming a trust as the beneficiary of your 401(k), IRA, insurance policies and other accounts has many benefits. It is the best way to:
- Undertake complex planning
- Make your wishes clear
- Establish a mechanism for carrying your wishes out
- Save time and heartache for your relatives down the line
The money will go into the trust after your death. Then, the trust will distribute the money to beneficiaries as dictated by its terms. This means that you can be much more specific about where the money goes.
Beneficiary designations are key components of many other kinds of plans, including annuities, Keogh Plans, and a wide variety of retirement plans available to business owners. These plans may have special rules. You should coordinate them carefully with the rest of your estate plan.
Your estate planning lawyer may also be able to help advise you and your beneficiaries on their options for receiving the bequest (lump-sum distribution, monthly pay-out, etc.); the interface between your decision about who to name as beneficiaries and your family situation, particularly in the case of blended families or divorce or separation; naming charities as beneficiaries; and how to handle contingent beneficiaries (those who you would like to receive benefits in case one of your primary beneficiaries dies).