IRAs, 401Ks, and Estate Planning

Wednesday, October 8, 2014

    For tax reasons, it is often wise to pass IRAs, 401Ks, and other tax deferred assets outside of probate, by making sure the beneficiary designations on these assets name actual individuals.

    Sometimes this can be counter productive, however.  Some of the ways in which this can be counter productive are discussed in another posting titled Tax Issues and Real World Protections for Inherited IRAs and 401Ks.

    IRAs, 410Ks, and the like are tax deferred assets.  This means that no tax was paid on the assets when they were first earned, and that they have grown free of tax since they were earned.  Ordinary income tax is paid on these assets when they are withdrawn.

    The person who creates these assets must continue to hold these assets in his or her own name during life.  They cannot be transferred to a trust during the life of the first owner.

    The first owner must also begin taking mandatory withdrawals from these assets when they reach the age of 70.5 years.

    The amount of the income tax owed each year is a function of the total income of the person taking the withdrawals.  If a person has little other income, the tax rate may be low.  If the person taking the withdrawal has significant income, to which is added this IRA or 401K withdrawal, the percentage of tax may be higher.

    This is because the more money a person makes, the higher the tax bracket the person is in.

    For this reason, it can be wise to defer withdrawals, if possible, until after a person stops working.  For the same reason, it can be wise to take out as little as possible in any given year, if taking more will result in the person moving to a higher tax bracket.

    When a person dies, the IRA or 401K is usually assigned by a beneficiary designation to someone else.  This other person may be called a successor beneficiary.

    Often, the owner of an IRA or 401K will designate someone who is significantly younger.  Because the mandatory deductions are calculated based on the age of the recipient, this can mean that the amount that must be taken out each year by the successor beneficiary can be reduced if the successor beneficiary is younger.

    If a person does not affirmatively make a designation of a successor beneficiary, and properly file this with the custodian of their IRA or 401K, the default terms (boilerplate) of their plan may come into effect.  Sometimes this boilerplate results in the asset passing to a descendant, sometimes to a spouse, sometimes to a combination of a spouse and descendants, and sometimes to the probate estate of the original owner.

    It is usually best to carefully plan these beneficiary designations, as part of a person’s overall estate plan.

    As with most estate planning issues, discussing the matter with a skilled and practical lawyer can be very helpful in choosing the most efficient path to follow.