Protecting Your Retirement Accounts

When discussing estate plans with my clients, I always make sure we discuss their retirement accounts (such as IRAs, 401ks, etc.). These are normally owned by only one person and have a beneficiary. Therefore they are not typically in a trust nor do they pass under a Will. What I have been finding is that often times their retirement accounts have the greatest value of any property they own, including their house. Because these accounts defer payment of income tax, their balances can grow very quickly, and can easily become worth millions over the course of generations.

With this in mind, I tell every client that they need to be absolutely sure they named a beneficiary for each retirement account. The beneficiary is the person or persons they want to receive the retirement account when they die. Many of my clients think they did. Many of them find out that they didn’t. You should contact your plan administrator to make sure you did. Retirement plans sometimes provide for a default beneficiary in the event you did not name one. Many times, however, your account will be left to your estate when you die.

This can be financially disastrous. Unless you leave your retirement account to a qualified beneficiary, it will be necessary to cash in the account and pay it out to your beneficiary. If your beneficiary is your estate, which is not a qualified beneficiary, your estate will have to pay income taxes on the payout. In other words, your $600,000 IRA is now worth only $400,000 to your family after taxes!

So, do not rely on hope that your plan has a default beneficiary designation. Check with your plan administrator that you have your own beneficiary designation on file. Get and keep a copy of that designation for your records so you (and your beneficiary) can prove that you made it.

One of the great things about leaving your retirement accounts to your children is that the accounts can “stretch out” over the life of each designated qualified beneficiary. For example, your son can “stretch” taking money out of the account over his life expectancy calculated from when you died. That is good since retirement accounts grow so rapidly by deferring the payment of income taxes. Your nest egg just became your son’s nest egg! But what happens if your son is the kind of guy that spends every penny he gets as soon as he can get it?

If you name your son as your direct beneficiary, he may decide he wants to spend that money now. As far as he’s concerned, inherited money is “found money.” Because your beneficiary didn’t work for it, he thinks of it as a freebie. Even though your son has the right to stretch out the retirement account over his lifetime, he may choose to ask for a lump-sum distribution instead.

This is definitely not a good idea. First, about one-third of the balance in your IRA is lost to payment of federal income tax. Second, that $600,000 IRA, whose balance could have grown rapidly and tax-deferred into millions of dollars over the next few decades, is gone in an instant.

A way to try to avoid this is by creating a specially designed revocable trust for your son, and designating that trust as your IRA beneficiary. Under IRS rules, a properly drafted trust can be used as a qualified beneficiary. Your son will no longer have the option of taking it all out at once. That will now be up to the trustee.

Trusts are prudent not only for family members that are spendthrifts. They might also be advisable if your child has special needs, is in a bumpy marriage, has creditor problems or is in a high-risk profession. Upon your death, the trust takes the retirement account and stretches it in a way that preserves it for that child and for future generations.