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Include Your Retirement Accounts in Your Estate

Estate planning is necessary to properly protect yourself, your assets, and your loved ones. While most estate planning focuses on physical property, like your home, and liquid assets, such as investment accounts, retirement plans can actually make up a large portion of one’s estate. Due to the specific tax rules governing these assets at death, you must plan carefully to ensure these funds are integrated properly into your estate distribution plans and tax savings strategies.

Include Retirement Plan Beneficiaries in Estate Planning

You probably named beneficiaries for your retirement accounts when you opened them. Who you named can impact your overall estate planning objectives, so when including your retirement assets in your estate, consider these questions:

  • Has anything changed in your life since then that would affect their status as your beneficiaries?
  • In what manner will they receive these retirement assets?

Revisit your beneficiary designations after major life changes like marriage, divorce, or the birth or adoption of a child. If you do not designate beneficiaries for your retirement accounts, the designation may default to your estate, which is one of the worst possible outcomes for your retirement accounts from a tax and planning perspective. (For related reading, see: The Importance of Updating Retirement Account Beneficiaries.)

If your estate is named a beneficiary, your heirs must wait until the probate process is complete before they can access your retirement accounts. That can be a painful process, not only from a time standpoint, but also due to the expenses and potentially adverse tax consequences. It is usually better to name an individual or a trust as your beneficiary.

At a minimum, you’ll want to name a primary beneficiary, and possibly contingent beneficiaries as well. Contingent beneficiaries are usually named in the event your primary beneficiary pre-deceases you. Different states have different requirements for who you can name as a beneficiary. Some states require you to name your spouse as the beneficiary of your 401(k) account unless they give their explicit permission to name another individual (like a child or other relative).

Protecting Retirement Funds With a Trust

Another option is to include a trust in your estate planning rather than distributing retirement funds directly to specific individuals. This can give you more control over the distribution while protecting your heirs from additional paperwork and taxes. If you want to leave the assets in your retirement accounts to a relative who you are afraid will not manage the funds well, you can use a trust to set up regular distributions from those accounts. Regular trust distributions prevent a beneficiary from accessing their inheritance all at once, or worse, spending it all at one time.

Trusts also work well if your beneficiaries include minor children who should not have direct access to the money until they become legal adults. (For related reading, see: Designating a Minor as an IRA Beneficiary.)

Required Minimum Distributions

Your retirement plans come with rules about when you are required to start taking distributions from them. These are called required minimum distributions (RMDs). For accounts like a 401(k), you are required to start taking RMDs at age 70.5. But if you pass away and leave retirement plans and accounts to your heirs, these rules apply to them instead, and they can be quite complex.

Although a spousal beneficiary can simply roll over your retirement funds (tax-free) into their retirement plan and make their own distribution choices, other beneficiaries do not have the same option. Understanding how the tax treatment and distribution options vary depending on who is receiving your retirement assets is a critical component in the overall estate planning process.

Some beneficiary designations may qualify for the stretch IRA provision, allowing them to withdraw their inherited retirement plan assets over the course of their lifetime, or they may be required to withdraw the entire balance within five years of your death. Knowing who your beneficiary is and determining what distribution rules apply to them, can make a substantial difference in how much of your retirement assets are actually passed on to your intended beneficiaries.

Tax Considerations

The biggest concern you need to address when designating retirement accounts as part of your estate plan is how they will be taxed. Retirement accounts are some of the most heavily taxed assets you can pass on after your death. When looking at your financial plan and your estate plan, determine how to withdraw from these accounts while you’re alive and how to minimize tax consequences after you’ve passed. (For related reading, see: How to Maximize Inherited Retirement Accounts.)

It can be beneficial to work with a team of professionals who have a deep understanding of retirement accounts and the legal requirements of estate planning. The end goal is to ensure your retirement assets are distributed to the proper beneficiaries with the least tax consequence. This can be accomplished by creating a withdrawal strategy that generates a retirement income coordinated with your Social Security claiming options, and is based on your lifestyle objectives, your overall retirement income and your tax status. 

(For more from this author, see: 10 Things to Know About Social Security Benefits.)