Passing Large Retirement Accounts to Beneficiaries

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Whether you've accumulated a large retirement account over a long and successful career, inherited one from a spouse who maybe passed away unexpectedly, or received a portion of your ex-spouse's retirement account post-divorce, knowing the tax and financial planning implications when that retirement account passes to your beneficiaries is a crucial part of your estate planning.

Hello, everyone, and welcome back to another episode of the Retired-ish podcast. I'm your host, Cameron Valadez, certified financial planner and enrolled agent. Today, we're discussing the estate and tax planning nuances that you need to be aware of if you have large pre-tax retirement account balances. In this day and age, with the lack of pensions offered by employers to rely on in retirement, these larger retirement account balances are becoming more common since most people are left to save completely on their own for retirement.

This could be because you and maybe your spouse have had a long and successful career on top of being a good saver. You may be working longer and continuing to save because you enjoy what you do, and you don't know what you would do with all your free time if you were to retire. Or maybe you're in something like the tech industry, and you've been fortunate enough to accumulate some highly appreciated employer stock in your company's retirement plan. It could also be because you've taken on or inherited retirement account balances from a spouse who maybe passed away unexpectedly or received part of their retirement plan from a divorce settlement. Whatever your case may be, understanding what will happen to that money when your own beneficiaries inherit it is paramount to your wishes and your legacy.

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Many people do some sort of planning with their retirement funds to provide income for their own retirement years, but they fail to consider what happens if there's money left over in the end to a spouse or adult children, other family members, and even charities. The retirement and tax laws that surround these types of retirement accounts and retirement plans are very complex, and they're ever-changing. In fact, since just the year 2020, the laws surrounding these types of accounts have changed several times. We've had new legislation pass and even additional IRS-proposed regulations on those pieces of legislation after the fact. And believe me, there will continue to be many changes as time goes on.

And making sure that your plans account for these changes year in and year out can help make sure that your estate planning wishes are carried out as you intended. If you don't adjust your plans regularly, tens, if not hundreds, of thousands of dollars, may slip through your beneficiaries' hands to the tax authorities. Luckily, with some good planning ahead of time, many of these inheritance blunders can be avoided.

So, let's dive in. First and foremost, I want to start off by saying that large pretax retirement accounts such as 401(k)s, traditional IRAs, and the like, they're not great for passing wealth efficiently.

Now, I don't want you to take this out of context in any way by mistake. They are not bad investment vehicles or accounts to have and save money into by any means. They just aren't the best vehicle for passing on wealth to most beneficiaries compared to other types of assets that you may have. In fact, they are great vehicles to save money into and accumulate because they can reduce your taxes during your working years when you're much more likely to be at peak levels of income. And because the growth and the earnings on the investments inside these accounts are not taxed each and every year, they are typically able to grow and compound faster than other types of investment vehicles.

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This is also sometimes referred to as a tax-deferred account. However, it's not enough to just simply accumulate a substantial amount of retirement assets. You also have to have a method of protecting as much of that money as you can from the IRS and possibly state tax authorities, depending on where you live. In other words, it's not all about the amounts that you have or that you've built. It's all about what you can keep.

Most people, maybe even you, who have these large retirement account balances tend to look at the amount and assume that all of that money is theirs. You know, when you look at it, and you feel really nice and cozy because it's a statement of how well you've saved, and you feel better about living the American dream. The problem is that the IRS has its hands in the cookie jar, too. Don't forget that. It's kind of as if the IRS is like a joint owner on your account with you now. Not technically, but you get the point. Generally speaking, when money is withdrawn from one of these pre-tax retirement accounts, the amount of money that you withdraw is subject to federal income taxes in the year that you withdraw it.

It may also be subject to state taxes. As I mentioned before, depending on the state that you live in. And if you take money out before you reach age 59 and a half, you may even incur a 10% penalty to boot, on top of the taxes. So, if you have, say, a million dollars saved up in a retirement account or multiple retirement accounts, do you really have a million dollars to spend throughout your retirement and possibly pass on to your family?

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No. As that money comes out, you will either pay taxes on it or your family members will. There are some exceptions to this we will get into a little bit later, like Roth accounts and charities, but for most of us, it's not all ours at the end of the day. As you've likely heard me mention before in previous episodes, this is why the distribution or spending phase of your retirement is so important to plan for. The accumulation phase, when you're saving money and working, is technically the easy part.

You just theoretically put money away and invest on a regular basis. The point here is that you can't necessarily do your own retirement income planning or your estate planning based on the balance that you see in your accounts because it's somewhat of a mirage. And that right there is the number one reason why these pre-tax retirement accounts are such a poor vehicle when it comes to transferring the wealth that you've built over your lifetime. Simply put, if, let's say again in this example, you have a million dollars saved in these types of accounts, you have done some planning, and you figured out that you will need around 700,000 of that to cover your retirement income needs over the rest of your own life. So then you say, hey, I want to leave the remaining $300,000 or so to my three kids.

Well, you will actually have to withdraw more than the 700,000 because you're going to have to account for your own income taxes. And on top of that, your kids won't necessarily get 300,000 because they will also be subject to taxes on that money. Instead, I would suggest not just sitting there and admiring the size of your IRA or your 401(k) but rather doing something about what you've accumulated sooner than later.

Now, the number two reason why these accounts are not the best for legacy planning is all of the complicated laws surrounding these accounts. Rather than bore you with all the small details of the current rules, I'll just try to summarize the major ones as of today in layman’s terms.

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Most of these rules stem from the most recent significant retirement legislation known as the Secure Act and Secure Act 2.0, and these general rules apply only if someone inherits a retirement account after the year 2020. If you want to see the more intricate details of some of these rules, I will add a link in the episode show notes for today's episode on some previous blogs we've posted on this.

Generally speaking, most individuals other than your spouse and charity that are specifically named on your accounts as beneficiaries will have to draw the money out of the account and pay taxes on that money within ten years after inheriting it. That is, the account will have to be completely drained by the end of the ten years, and they can't just let it sit there and accumulate without paying any taxes. Let's say for their own retirement.

They may even be forced to take small chunks in each of the years, one through nine, in addition to making sure it's empty by year ten. And this will depend on the exact circumstances. If no one is named as a beneficiary, the default beneficiary will be your estate, and generally, the money will need to come out within five years, or your would be remaining life expectancy had you lived. Again, which one depends on the exact circumstances of your situation.

This type of situation is usually not ideal since even if you do have heirs that you want your money to go to, maybe you have a will that says, hey, these things are going to my kids and my niece and nephew, or something like that, they will still have to go through probate to get it, which is expensive and often very cumbersome. They may have to drain it even faster than the ten-year rule, which could also mean that they will pay more in taxes. So be very careful of this.

Now, if you specifically name a charity as a beneficiary, they generally don't pay any taxes, so there's not too much to worry about there, which can actually make these accounts a great way to leave money to the causes that you care about. I'll talk a little bit more about this later.

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And lastly, there are some special types of listed beneficiaries that have more favorable rules as far as how long they have to withdraw the money and pay the taxes. But for the purposes of this episode, I want to just focus on one, which is a surviving spouse. Spouses have a couple of different options to weigh depending on what may benefit their situation best.

Okay, so now that you have a general idea of what may happen, what are some of the things that you should consider doing about it, and what strategy should you be careful of? Well, as it relates to most adult children who are listed as a beneficiary on one of these accounts. And by the way, this could be you right now. As a beneficiary of one of your parents' retirement accounts, these beneficiaries will have to empty the account generally within ten years after the owner passes. They have at least some flexibility on how they go about it. But again, that depends on the exact circumstances. They may be able to let it grow for their own retirement needs for the entire ten years. However, that would mean that in year ten, they would have to distribute the entire account in one taxable lump sum.

This tends not to be a good thing because the larger the amount, the higher the risk of it creating a tax bomb that will potentially increase the tax bracket they are in, cause more of their Social Security to be taxed, or even subject them to extra surcharges on their Medicare premiums. It can also mess with a lot of other potential deductions that the beneficiary may have been used to taking. Doing it this way can be very dangerous. Therefore, a hefty chunk of the money that you or your parents worked so hard to save could be lost to the tax authorities. And I would bet that you or they didn't intend on making the IRS one of your beneficiaries.

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Not to mention the fact that depending on how the money was invested, the account balance may be far larger than the original amount that the beneficiary inherited, which could then again mean more taxes paid. These same issues could arise even if the beneficiary chooses to liquidate the entire account in one lump sum, in, let's say, the first year that it's inherited, or in any one-year period for that matter. To avoid some of the tax damage, a beneficiary may consider trying their best to evenly spread the withdrawals out over the ten years, or they can even get more creative. And again, when I say they, this could mean you, too, if you are to inherit a retirement account. Let me give you an example of what I mean by getting a little more creative.

Let's say that your only child is going to inherit your IRA and wants to preserve as much of it as possible. Let's also say that by the time it passes to them, they are three years away from their own retirement, and they will have far less income once they retire than they did while working. They may be able to take little to no distributions from that inherited account in the first three years until they retire. Then, they might accelerate some withdrawals out of that account after they retire. The reason they would do this is in order to try to stay in lower tax brackets and spread it out evenly over their retirement or the remaining seven years.

I want to remind you that depending on the exact circumstances, they may actually be forced to take a minimum amount out in each of the years one through nine, so they may not be able to completely avoid taking anything in my example, let's say in the first three years. Again, it just depends on the situation, but either way, there is some flexibility here. Now, you might also consider a plan to implement Roth conversions during your lifetime in order to move those pretax retirement accounts into a tax-free Roth account. When inherited, these Roth accounts will also have that ten-year rule that I mentioned for your adult children, but the money won't be taxable to them, and they can let it stew for the full ten years if they want. Then, take a giant lump sum distribution at the end, and remember they won't get taxed on it.

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This is some really cool stuff. As an important side note, please remember that when talking about Roth conversions, if you were to do a Roth conversion, the amount that you convert is generally all taxable in the year that you convert it. And by the way, we have other episodes that discuss Roth conversions, what they are, and how they work, as well as some blog posts, so be sure to check the episode show notes to learn more. Another great strategy to potentially use here is if you have other assets that are not retirement accounts, things like properties or the home you live in, for example. In this case, instead of naming, let's say, your three children as equal beneficiaries of everything that you own, you may consider leaving the retirement account to one or two of them and the property to another, or vice versa.

You would do something like this if maybe one or two of your children have significantly different tax situations, like one is in a really high tax bracket, and one or two more are in lower tax brackets. You would ideally leave the retirement money, in this case, to those in the lower brackets and the other assets like the property, for example, to the others. This can also help avoid family tussles between the kids. If all three, let's say, were to inherit the property and everything else equally, and they all want to do something different with it. If this sounds like you, get with your advisors to draw up a plan that can make things as equitable as possible for your kids. There are, of course, more creative things an adult child beneficiary can consider in these situations. But let's move on to what happens if a spouse inherits one of these pretax accounts.

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As I mentioned before, spouses who are listed as beneficiaries on a retirement account have a few more options when it comes to inheriting the money. In general, they can treat the deceased's IRA as their own IRA. They can roll the money into their own IRA, or the other option is to accept it or take it on as what is called an inherited IRA or beneficiary IRA, similar to some of the other types of beneficiaries I've mentioned, like an adult child. Again, I won't get into the exact nuances of these options but just know that there can be more flexibility on what a surviving spouse can and cannot do depending on how they choose to take on the money. This will ultimately depend on their age and their goals for the money.

For the exact rules and options for your situation, it is definitely best to reach out to an experienced financial planner or tax advisor, and I can't stress this enough. Experience is the keyword here. These laws are so intricate that things get overlooked all the time, even by professionals. Scary. If you don't believe me, there are a plethora of tax court cases out there that serve as prime examples of misunderstandings of the rules. In fact, I just got back from an IRA expert tax conference for professionals, and it was shocking how many were unaware of some of the nuances of retirement accounts.

One of the latest cases came from the estate of the late actor James Kahn, whose beneficiaries found themselves in an inheritance nightmare with his accounts. He even had a high-priced financial advisor in Beverly Hills. The point is, no one is immune to this. Other than deciding between how to take the money, what else might a spouse beneficiary consider? Well, just as in the last case with adult children, you may want to consider doing things like Roth conversions to get more of your money in tax-free Roth accounts before one of your beneficiaries inherits it.

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This leaves your beneficiary with far more flexibility and fewer complications when they inherit the money. In addition, if your spouse is your primary beneficiary, inheriting Roth money instead can do wonders for their tax situation since they will more than likely be filing their taxes as single going forward, which typically causes them to pay more in taxes. Another strategy, or sort of a caveat to this, is that the surviving spouse will actually get the opportunity to still file married joint on their tax return in the year their spouse passes. This means that if they choose to take on the IRA as their own IRA, they may consider converting some or all of it to a Roth IRA before the year-end so that they can get a little more of a tax benefit as opposed to doing it in a later year where they will be filing single and it might blow up their tax situation. This particular strategy is even better if you also have a life insurance policy on you.

Your surviving spouse, in theory, would receive the life insurance proceeds tax-free, and then they could use some of that money to pay the taxes due on a Roth conversion. This might make it easier for them to convert the majority of the money sitting in the taxable retirement account.

For those of you who are charitably inclined and want some of your money to go to a cause that you care about, these large retirement accounts can be a great way to do that. Pretax retirement accounts are one, if not the best types of accounts to leave to a charity. This is because most charities generally don't pay taxes.

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This means that the actual amount in your account that you want to leave to them they will actually get. Simple as that. However, if you have already done some estate planning, be sure to revisit that plan. If your current will or a trust, let's say, says that you are going to leave maybe a percentage of all of the assets you own to a specific charity, you may want to change that to just the retirement account or a portion of it and leave the other non-retirement assets to your other heirs. In most cases, your heirs will have a better tax outcome because of this, and obviously, so will the charity.

As I say, two birds with one stone. Also, make sure that if you decide to go this route, changing your legal documents likely won't be enough. You would need to make sure that you actually name the charity as a beneficiary on your actual retirement account. You don't want to just go into your will or your trust and say, hey, I want my retirement account to go to the charity. The retirement account beneficiary form will supersede whatever your will or trust says.

All right, so the last subject I want to tackle is leaving your retirement accounts to your personal living trust, otherwise known as your revocable living trust. This seems to be very common these days, especially for those who have large balances in their retirement accounts, because it's oftentimes not the only asset that they own. So, they get a trust created for the rest of their assets. Many people will end up naming their trust as the beneficiary of their retirement account because they see it as the “easy button,” like in the old Staples commercials. Other times, it might be because they went to an estate planning attorney to get their trust made, and the attorney gave them a piece of paper that essentially said, hey, go put all of your assets into the trust.

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Even if the estate planning attorney knew better, the individuals were ultimately responsible for funding their own trust, and there are certain assets that you really can't put into a trust. Retirement accounts are one of them. So they say, hey, I got a trust created by an attorney, and all of my wants and wishes are in there, so if the account goes to my trust, I'm good. I'm here to tell you that that is not often the case.

While it seems like that would make sense in most cases, it actually makes things much more complicated and simply unnecessary. Due to the more recent retirement and tax law changes, leaving a trust as a beneficiary is now much harder to do in an efficient manner. This is one of those areas where there is still a ton of misunderstanding, even between professionals such as attorneys, tax professionals, and financial advisors. And after all, the laws are very complex, and they're still relatively new. And while the exact rules are too complex to discuss on this podcast, in general, there are some things that you'll want to know about trusts and retirement accounts.

And the first is that labeled individual beneficiaries on your actual retirement accounts will supersede whatever your will or trust says if you have, in fact, labeled individuals as beneficiaries. So, as a hypothetical example, even if your trust says, hey, I want my three children and my favorite charity to split my retirement account evenly between the three or four. But then your retirement account only has the kids listed as beneficiaries. Generally, nothing will go to the charity. Because of this, if you have a basic estate plan and just want your account to go to your spouse or your kids, you generally just want to list them as beneficiaries directly on the account.

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More often than not, in these situations, a trust may not be needed for the retirement account to pass efficiently. However, with all that being said, there definitely are some circumstances where you may want to list your trust as a beneficiary on your retirement account. One common example is if one of your beneficiaries has special needs and is on some sort of public benefit. In these cases, a trust may make sense since it might be able to protect them by not blowing up any public benefits that they're receiving because they just inherited a lump sum of money. This is just one example. There are more, of course.

And lastly, there are what some are calling IRA trusts out there, so-called designed a special way for a retirement account, like an IRA. But again, if you have a rather basic estate plan, these trusts are likely not needed, no matter what the name of them is. In fact, they may even create more costs to your beneficiaries due to the fact that a trustee will need to manage that trust on behalf of the beneficiaries after your death, and trustees are typically able to charge additional fees in order to do that. But if it wasn't really necessary to begin with, why would you want to potentially pay these additional fees and complicate things?

To sum this episode up, here are some additional things to avoid and or consider. In most cases, you'll want to avoid not naming any beneficiaries at all on your accounts or purposely naming your estate. This rarely turns out well. Make sure you review your beneficiaries and your estate plan on a regular basis. Life changes, things happen, and people tend to forget to update things. At my firm, Planable Wealth, we aim to revisit this with clients at least once a year.

Don't assume that because you have a will or a trust, everything will pass as you intended. That is, don't make the mistake of simply stating in your will or trust that you want your retirement account to go to XYZ beneficiary or charity. Beneficiary designations on the accounts themselves will override whatever your will or trust says. In fact, if you only have a will and you don't name any beneficiaries on your accounts, it will still go to your estate and be subject to probate.

Creating a living trust in and of itself does not provide any tax benefits for you or your retirement account. Only name a trust if you are absolutely certain that you have to due to very special language in your trust or possibly having special needs beneficiaries.

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Trusts as beneficiaries of retirement accounts often cause more harm than good due to the most recent legislation. So get with your tax professional, financial advisor, or attorneys and nail down a solid plan if this is the case. Understand how your beneficiaries will be affected once they inherit the money based on your plan. Again, this could be your spouse, your children, or some other beneficiary. You may say, hey, I don't care because I'll be out of the picture.

However, if everything is messy, more of that money you worked your butt off for will disappear, and you'll likely be rolling over in your grave. And consider using life insurance as part of your estate plans. You may be able to use some of your large retirement account balance throughout your own lifetime to maybe pay for a life insurance policy in which you can leave a tax-free death benefit to your beneficiaries instead of a tax-ridden retirement account. What's even more important is that you may be able to purchase long-term care insurance as well.

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That does it for today's episode. If you are concerned about your own planning, your legacy planning, and your retirement accounts, or you need assistance in helping a loved one, such as your own parents, with this kind of stuff, our firm, Planable Wealth, has experience navigating the financial aspects of retirement accounts and the myriad of complications that come with them. You can find us at planablewealth.com or via our podcast website at retiredishpodcast.com, which is accessible in the episode show notes.

It's 2024, and that being said, we have a new 2024 tax cheat sheet as a free gift for download when you join our Retired-ish newsletter. This will provide you with the important tax numbers and thresholds for your personal tax and financial planning throughout the year 2024. In addition, if you check out our website at retiredishpodcast.com, we are offering a free download for my firm's retirement planning quick guides, which includes multiple flowcharts and resources to help you make financial decisions and implement some of the things we've discussed on the podcast. So be sure to check that out.

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