Beneficiary and estate planning for retirement accounts

Good beneficiary and estate planning for retirement accounts starts with the beneficiary form, not the will. An individual retirement account or an employer plan passes by contract. The custodian or the plan administrator reads the designation it has on file and pays the person named there. A will signed years later that says something different does not change that result, and neither does a handwritten note in a desk drawer. Most families learn this at the worst possible moment, a few weeks after a death, when the executor pulls the account statement and finds a name the owner had not thought about in a very long time. One page filed with a brokerage can move more money than an entire estate plan. That same page usually keeps the account out of probate, which normally helps the family, because the money reaches the named party without waiting on a court calendar. Tax reporting follows the same path. The custodian issues Form 1099-R in the name of whoever actually received the distribution, and that person reports it on a Form 1040 return for the year the money came out.

Two small words on the form decide what happens if a child dies before the parent does. Per stirpes pushes that child’s share down to that child’s own descendants. Per capita splits the account only among the beneficiaries who are living on the date of death, so the grandchildren in that branch receive nothing at all. Custodian forms differ from each other, and a number of them default to per capita unless the owner writes in something else. Run real numbers and the gap becomes obvious. Say an IRA holds 600,000 dollars and three children are named in equal shares, and one daughter dies first, leaving two children of her own. Under per stirpes her branch still takes 200,000 dollars, divided into two shares of 100,000 dollars. Under per capita her two brothers take 300,000 dollars each and her children are left out. The distribution rules that then apply to each inherited share sit in Publication 590-B, and the contribution and rollover side of the same subject is covered in Publication 590-A.

Who gets named matters as much as how the shares are worded. A surviving spouse has choices nobody else has, including treating the account as her own or rolling it into her own IRA. A non-spouse individual is a designated beneficiary and generally lands on a ten-year clock. An estate is not a designated beneficiary at all, and the result is worse. A trust works only if an attorney drafted it to meet the see-through rules. The common mistake we see more than any other is a stale form after a divorce. State law may cut off a former spouse for some accounts, but the federal rules that govern employer plans frequently ignore the decree, and the plan pays the name on file. Married participants face a second trap, because a spouse generally has to consent in writing before anyone else can be named as the primary beneficiary of a qualified plan.

Pull every designation once a year, then save the custodian confirmation with your tax records instead of trusting memory. Our bookkeeping team keeps that file current for clients who still hold accounts at three or four former employers, and our tax strategy consulting group models what each named party would actually owe on the money. Reading the general individual rules in Publication 17 before that meeting helps you ask the custodian sharper questions. Look at the forms again after a marriage or a divorce, and again after a birth or a death in the family, because the version you signed a decade ago is the one a custodian will honor.

Under current law most non-spouse designated beneficiaries have to empty an inherited retirement account by December 31 of the tenth year following the year the owner died. The clock counts ten calendar years, not ten payments. Whether annual withdrawals are also required inside that window turns on one fact, which is whether the owner had already reached the required beginning date for lifetime distributions before death. If the owner had already started taking required minimum distributions, the beneficiary keeps taking an annual amount during those ten years and clears the remaining balance by the final deadline. If the owner died before that date, no annual amount is required and the beneficiary picks the timing, as long as the account reaches zero on time. The mechanics are laid out in Publication 590-B, and every withdrawal is reported on Form 1099-R for the year it is paid.

Timing is where the tax bill is won or lost. Suppose a daughter who earns 90,000 dollars inherits a traditional IRA holding 500,000 dollars. Taking roughly 50,000 dollars a year for ten years adds a steady layer on top of her salary and keeps most of the money in the middle brackets. Waiting and pulling the entire balance in year ten piles it onto her wages inside a single filing season, forces a large slice into the highest bracket she faces, and can raise the income figure used for Medicare premium surcharges two years later. The account also keeps growing during the wait, so the year-ten number is usually well above 500,000 dollars. Level withdrawals are not automatically right either. A year with unusually low income or a large deduction is often the year to take more than the average, and reporting lands on her Form 1040 either way.

A short list of beneficiaries may still stretch withdrawals over life expectancy. Current law calls them eligible designated beneficiaries, and the group is narrow. A surviving spouse qualifies. So does a minor child of the account owner, but only until that child reaches the age of majority, at which point the ten-year clock starts and the account has to be emptied within ten years after that birthday. A person who is disabled or chronically ill under the tax definitions qualifies. So does any individual who is not more than ten years younger than the owner, which is how a sibling close in age or a partner of similar age can still use a life expectancy schedule. A grandchild does not qualify under the minor child branch, because that rule looks only at the owner’s own children. General individual guidance appears in Publication 17, and employer plan mechanics are described in Publication 560.

Roth accounts are not exempt from the ten-year rule, and that catches people off guard. An inherited Roth IRA still has to be emptied inside ten years, though there is generally no annual required amount along the way, because a Roth owner is treated as having died before the required beginning date. Qualified withdrawals remain free of income tax once the five-year holding period is satisfied, which makes an inherited Roth the account to leave alone the longest. The common mistake is the exact opposite habit. Beneficiaries drain the Roth first because it feels free, let the pretax IRA compound untouched, then face a far larger taxable balance at the deadline. Our tax strategy consulting team builds a ten-year withdrawal schedule against projected income, and our individual tax return group files the result each spring. Sound beneficiary and estate planning for retirement accounts sets that schedule in the first year after a death rather than the ninth, so map all ten years now while every option is still open.

An estate is not a person, so it cannot be a designated beneficiary. When the estate ends up as the beneficiary, the account loses the ten-year schedule and falls back to an older set of rules. If the owner died before reaching the required beginning date, the whole balance generally has to come out within five years. If the owner died on or after that date, payments run over what would have been the owner’s remaining single life expectancy, a figure that is often short for someone who died in their late seventies. Either path is worse than what an individual beneficiary would have received. The account also lands inside probate, which exposes it to creditor claims and to the delay of a court process. Consider an IRA holding 300,000 dollars payable to the estate of an owner who died at 62. The five-year rule pushes roughly 60,000 dollars a year of taxable income out to the estate or to the heirs who receive it, and the estate reports that income on a fiduciary return, Form 1041, which is filed separately from any individual return. The underlying distribution rules are in Publication 590-B and the payments themselves appear on Form 1099-R.

Trust taxation makes the problem sharper. A trust reaches the top ordinary income bracket after only a few thousand dollars of retained income, while an individual with the same amount would still sit near the bottom of the rate table. A conduit trust passes each distribution straight out to the named individual, who then pays at personal rates on his own Form 1040. An accumulation trust holds the money inside the trust, which may be exactly what a family wants for a young or vulnerable heir, but the price is trust rates on whatever stays there. Neither design is automatically better. The choice depends on why the trust exists in the first place, and that is a conversation for the family attorney.

A trust can qualify as a see-through arrangement so the underlying human beneficiaries are looked at for the payout schedule, but only if it satisfies specific conditions. The trust has to be valid under state law. It has to become irrevocable at the owner’s death. Its beneficiaries have to be identifiable from the instrument itself. Documentation has to reach the plan administrator or the IRA custodian by October 31 of the year after the year of death. Those are drafting problems, and they belong to the client’s attorney. The Reed Corporation does not practice law and does not draft trust instruments. What we do is read the finished document with the tax result in mind and tell the family what each version would cost.

The common mistake is a blank line. When nobody is named, the plan document or the IRA agreement supplies a default, and that default is frequently the estate. A second version of the same mistake is naming the estate on purpose so the will can control everything, which trades a decade of tax deferral for tidy paperwork. Naming minor children directly causes a related headache, because a custodian will not hand a large balance to a child and a court may have to appoint someone to receive it. Our tax strategy consulting team compares the after-tax outcome of each candidate beneficiary before anything is signed, and our bookkeeping team tracks the resulting distributions once payments begin. Ask the attorney to confirm the trust language and the custodian to confirm the form on file during the same month, because the two documents only work when they agree.

Two separate required amounts can apply in the year an account owner dies. The first is the owner’s own required minimum distribution for that year. If the owner had reached the required beginning date and had not yet taken the full amount before death, the beneficiary has to take whatever remains, and it is taxed to the beneficiary rather than to the person who died. The second is the beneficiary’s own annual amount, which applies inside the ten-year window when the owner died on or after the required beginning date, and which applies every year for an eligible designated beneficiary using a life expectancy schedule. Both figures are computed separately and both can land in the same tax year, which is one reason the year of death often produces a larger bill than the family expected. Life expectancy factors and the worksheets that go with them are published in Publication 590-B. Amounts paid during the year show up on Form 1099-R, which is the document to reconcile against the schedule before the return is filed.

Missing a required amount carries an excise tax on the shortfall rather than on the whole account. Under current law that excise tax is 25 percent of the amount that should have been withdrawn, and it drops to 10 percent when the shortfall is corrected within the statutory correction window and the required return is filed. Take a beneficiary whose annual amount was 12,000 dollars and who withdrew nothing at all. The excise tax at 25 percent is 3,000 dollars. Fixing it quickly by taking the 12,000 dollars and filing the correction reduces the exposure to 1,200 dollars. The tax is reported on Form 5329, and the same form is used to ask for a waiver where the shortfall happened for reasonable cause and steps were taken to fix it. Requests of that kind are granted often enough to be worth filing, but no outcome can be promised, and the request has to describe what went wrong in plain factual terms. Any balance that ends up owed can be paid through IRS payment options, and interest keeps running until the account is settled.

Aggregation rules trip up careful people. An owner may add up the required amounts across her own traditional IRAs and take the total from any one of them. A beneficiary may add up inherited IRAs received from the same decedent and take the total from one of those. Inherited accounts can never be blended with the beneficiary’s own IRAs, and accounts inherited from two different people can never be blended with each other. Employer plan balances each stand on their own and do not join any of these groups, so a 403(b) account and an IRA are counted apart even when the same person owns both. The common mistake is a family that treats every account as one pot and pulls the whole year’s total from the largest one, which leaves a real shortfall on a different account and creates an excise tax nobody sees coming until a notice arrives in the mail.

Verify rather than assume. Compare each custodian statement against the schedule, pull an account transcript through IRS transcript access when the records are incomplete, and keep the year-end fair market value that drives next year’s calculation. Custodians will often compute the figure for an account they hold, but they cannot see the accounts held elsewhere, so the final number is still the taxpayer’s responsibility. Our individual tax return team runs that reconciliation as part of the annual file, and our bookkeeping team keeps the statements organized so the numbers are ready in January instead of April. Set a calendar reminder for early December each year, because a shortfall caught in that month is a phone call and the same shortfall caught in February is a penalty conversation.

The Reed Corporation is a CPA and tax firm. It is not a registered investment adviser, it does not sell or manage retirement products or insurance products, and it does not practice law or draft trust instruments. Nothing on this page is legal advice, and nothing here is a recommendation to buy or hold any investment. What the firm handles is the tax side of the decision, working alongside the client’s own attorney, the plan custodian, and the client’s licensed financial advisor. That division of labor exists for a reason. An attorney writes the trust that will satisfy the see-through conditions and answers the state law questions that come with it. A custodian records the designation and pays the named beneficiary when the time comes. A licensed advisor handles the portfolio itself. We calculate what each of those choices costs in tax and put the numbers in front of the family before any document is signed, then we file the returns that follow.

The work itself is concrete. We read every current designation and flag the accounts where the primary or the contingent line is blank or out of date. We model the ten-year schedule for each likely beneficiary against that person’s projected income. We track basis from any after-tax contributions, because a beneficiary who ignores basis pays tax twice on the same dollars. We also watch how a large distribution interacts with the 3.8 percent tax on net investment income reported on Form 8960. A retirement distribution is not itself net investment income, but it raises modified adjusted gross income, and that can pull dividends or capital gains into the tax. Picture a beneficiary with 40,000 dollars of investment income who takes 250,000 dollars from an inherited IRA in one year. The distribution is taxed as ordinary income, and the higher income figure can also expose that 40,000 dollars to the additional 3.8 percent, which is 1,520 dollars of tax that a smoother withdrawal pattern might have reduced or avoided.

Plan type changes the details, so we confirm what the account actually is before advising on it. A profit sharing or SEP arrangement described in Publication 560 follows different plan document terms than a 403(b) arrangement covered in Publication 571, and both can differ from a plain IRA governed by the rules in Publication 590-B. Employer plans may also force a faster payout than the tax law requires, because a plan document is allowed to be more restrictive than the statute even where the statute would permit a longer schedule. That is why we ask for the summary plan description rather than relying on a general rule. Clients who want the full picture in one sitting can request a consultation and bring the plan summary along with the most recent statement for each account.

The common mistake at this stage is treating the beneficiary form as an administrative chore handled by whoever answers the phone at the custodian. It is the single most powerful document most families sign, and it operates without review on the one day it is needed. A second habit worth breaking is keeping the plan a secret, because heirs who learn the structure for the first time at a funeral rarely make good tax decisions in the weeks that follow. Our tax strategy consulting group keeps a standing schedule of designations for each client household, and our individual tax return team checks that schedule against the forms filed each year. Careful beneficiary and estate planning for retirement accounts is never finished, so revisit the designations after any change in the family and again whenever the law shifts, and bring the attorney into the same conversation so the trust and the form finally say the same thing.