Are You Helping or Hurting Your Beneficiaries?

By Alan B. Cohn, Esq.

Most people make IRA and qualified retirement plan beneficiary designations without giving nearly as much thought as they should to the tax and economic consequences of their designation.  This is especially surprising when one considers that for many people, an IRA or qualified retirement plan is the biggest single source of liquidity (with the possible exception of life insurance proceeds) their estate will have.

The beneficiary designation has important economic consequences.  For example, if an individual has been careful to establish a trust for his or her spouse or children, not just to minimize estate taxes, but in order to enable a trustee to supervise investments and distribution of the funds of the estate, it makes little sense for the individual to name the spouse as outright beneficiary of IRA and retirement plan distributions with children as outright alternate beneficiaries. Instead, the trust should probably be designated beneficiary to be consistent with the estate plan.

The income tax consequences of the beneficiary designation can be significant because qualified retirement plan and IRA funds accumulate tax-free until distribution, but are then taxed fully on distribution (assuming no rollover) depending on factors such as the amount in the IRA and the beneficiary's other income. It may be important that funds be distributed in installments over the beneficiary's lifetime in order to stretch out for years the time over which income taxes will need to be paid, and perhaps to lower the rate at which they will be taxed.

If the beneficiary is an individual, lifetime installment distributions can normally be accomplished through an IRA, but retirement plans may not offer as much flexibility.  At one time, distributions (other than certain distributions to surviving spouses) could not be rolled over after a participant's death from a retirement plan to an IRA, limiting a beneficiary's flexibility as to distributions.  The law now permits beneficiaries -- even non-spouse beneficiaries -- of a deceased participant to rollover funds in a qualified plan to an IRA.  Once in the IRA, the funds can be distributed over the beneficiary's lifetime, prolonging for many years the payment of income taxes.  However, the beneficiary designation must meet certain requirements for the beneficiary to be able to make such a rollover.

Both retirement plan funds and IRA funds are includible in the decedent's estate, even though they are not distributed at the time of the decedent's death.  This means, for example, that in a taxable estate in which the marital deduction is not available (i.e. on the first spouse's death, retirement plan funds were rolled to an IRA, much of which remains undistributed at the death of the surviving spouse), there will be an approximately 45% estate tax.  If the estate distributes funds from the IRA to pay the estate taxes, the distribution will be subject to income taxes.  Suppose, for example, the decedent dies with a $2 million IRA.  The estate taxes, if no marital deduction is available, would be approximately $900,000.  If the estate taxes are paid from the IRA, approximately $1.4 million will need to be paid from the IRA, because there will be approximately $500,000 of income taxes in addition to the estate taxes.  Instead, if other proceeds, such as life insurance, could be used to pay the estate taxes, the beneficiaries of the decedent would be able to allow a $2 million IRA fund to continue to accumulate monies income tax free with only the distributions being taxed.

With a larger estate, there is rarely a perfect solution to these issues.  Therefore, it is important to discuss beneficiary designation and tax planning alternatives with a qualified estate planning attorney.

Alan B. Cohn, Esq. is a shareholder at Greenspoon Marder, where he concentrates his practice in the areas of Tax; Estate Planning & Probate; Guardianship; and Business & Corporate law. Mr. Cohn is Board Certified by the Florida Bar in the areas of Wills, Trusts & Estates. He can be reached at alan.cohn@gmlaw.com or 954-491-1120.