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Estate Planning with Retirement Benefits

As a general matter, retirement benefits are pretax dollars that have been invested on behalf of an employee. Accordingly, when the employee, or his designated beneficiary, ultimately receive the funds, they will be subject to ordinary income tax.

There is little that can be done to minimize taxes once mandatory distributions have begun, that is April of the year following the employee attaining the age of seventy and one-half. Basically, the employee must take mandatory distributions calculated to exhaust the entire balance of the retirment plan by the end of the employee's life expectancy. However, there are many occasions when an employee dies with a balance remaining in his or her retirement account. This is the circumstance where simple steps can result in large tax savings and deferral.

Once an employee receiving retirement benefits passes away, the employee's beneficiary designation controls the ultimate tax consequences. Generally, the designated beneficiary is either a spouse, child/children, or the decedent's trust or estate. There are three available transfers with the following resulting tax consequences:

1. If the beneficiary is employee's spouse, the spouse can always roll over the Plan assets into a new IRA, giving the spouse the ability to use his or her own life expectancy, achieving further tax deferral. This ability to roll over Plan assets is limited to employee's spouse, and only if the beneficiary is the spouse individually, not a trust for his or her benefit unless the spouse has the right to withdraw the Plan assets from the trust. Although the spouse has other options, rolling over Plan assets will almost always be the best choice.

2. If the beneficiary is not employee's spouse and if employee dies prior to attaining seventy and one-half, there are two options.

        a.  If the beneficiary is a named designated beneficiary under the retirement benefit plan, then the beneficiary can withdraw Plan assets over his or her life expectancy.

        b. If, on the other hand, the beneficiary is not a designated beneficiary under the retirement benefit plan but instead receives the plan funds pursuant to a trust or estate bequest, then the beneficiary must withdraw the entire balance of the retirement account (and pay income taxes on the withdrawal) within 5 years of employee's death.

3. Finally, if employee dies after the turning seventy and one-half and beginning his mandatory distributions, then a designated beneficiary named in the retirement plan has the option of  withdrawing Plan assets over the longer of the the beneficiary's life expectancy or employee's remaining life expectancy. If there is no designated beneficiary named in the retirement plan documents, then the ultimate beneficiary, who generally takes pursuant to a trust or estate bequest, is required to withdraw the funds over employee's remaining life expectancy.

    The difference between being required to withdraw an entire retirement account over five years versus a younger beneficiary's life expectancy could be very significant. Simple math illustrates that removing 1/5 of something is far greater than removing 1/30.

    All taxpayers should review their retirement plans to ensure they are maximizing the available tax benefits. Often times, people name their trusts or estates as the beneficiary which automatically precludes the use of a beneficiary's longer life expectancy.