12 February 2016

Five Traits of Retirement Plans (Traits 4 & 5)

We started this series of articles two weeks ago by noting the five key traits of qualified defined contribution retirement plans, such as profit-sharing plans or 401k plans, and IRAs. We mentioned the need to consider these characteristics when planning for these assets, including dispositions upon the plan beneficiary’s death.

The traits that we listed were:

  1. Plan income grows tax free;
  2. Plan distributions carry an income tax liability;
  3. There are required plan distributions;
  4. There are restrictions on transferring interests in these plans; and,
  5. The plan beneficiary has primary responsibility for distributions and transfers.

Last week we addressed traits 1–3. Specifically, we addressed the tax deferral on plan earnings, the taxation of distributions and the rules on required minimum distributions (RMDs).  This week we address traits 4 and 5. We will focus on the restrictions on transferring interests in these plans and the responsibility of the beneficiary for his or her plan.

Trait 4: There are restrictions on transferring interests in these plans.

A retirement plan beneficiary, whom we will call the “original beneficiary,” generally cannot transfer a retirement plan during his or her lifetime.  An exception to this rule permits a lifetime transfer in the case of a divorce.

The original beneficiary can designate what will happen to the retirement plan on the original beneficiary’s death, subject to a few restrictions.  The most significant restriction applies if the original recipient is survived by a spouse.  Unless the original beneficiary’s spouse consents, the beneficiary may have to leave at least some portion of the plan’s assets to the spouse.

After a transfer of the retirement plan interest, the plan continues to avoid taxes on its income.  Rather, the income tax liability is deferred, and a beneficiary will eventually pay the taxes when the money is distributed from the plan.

As to the transferred interest, there is a Required Minimum Distribution or RMD.  This RMD is computed differently for the person who inherits the account versus the RMD for the original beneficiary.

If the original beneficiary transfers the interest to a spouse, the spouse may, among other options, roll the interest over into an IRA and treat the IRA as his or her own.  The spouse may then delay taking distributions until the year after he or she reaches 70 and one-half years of age.  Also, the spouse will calculate the RMD according to the spouse’s life expectancy.

If the original beneficiary transfers the interest to an individual other than his or her spouse, the RMD depends on whether that individual meets the tax law definition of a “designated beneficiary.”  A beneficiary who meets that definition may stretch out the distributions over his or her lifetime.  Also, the original beneficiary may give portions of the retirement account to different individuals.  In many cases, each recipient may qualify as a designated beneficiary and receive the benefit of deferring distributions.

Special rules apply in the case of a trust.  The original beneficiary may transfer the interest to a trust.  Depending on the trust terms, the trust beneficiaries may meet the definition of designated beneficiary and qualify for tax deferral.

If the original beneficiary transfers the interest to someone other than a designated beneficiary, that beneficiary must withdraw the assets and pay all of the tax in five years.

In some cases, the original beneficiary may wish to leave the interest so that anything remaining after the original beneficiary’s spouse’s death passes to the original beneficiary’s children.  The original beneficiary with children from a previous marriage may be particularly interested in such an arrangement.  The recipients in this situation may not qualify as designated beneficiaries who benefit from tax deferral.  A subsequent article will discuss some solutions to this problem.

There is another important point to note.  The retirement plan is potentially subject to estate tax as well as income tax.  The estate tax will apply if the total of the person’s assets exceeds a specified threshold.  Currently, a person can leave up to $5.45 million (potentially net of past gifts) without having to pay estate taxes.  With this threshold, many people find that they no longer have to worry about estate tax.  Nevertheless, the estate tax is still out there and could apply to larger estates.  Of course, the income tax due on distributions from the retirement account would apply regardless of the size of the beneficiary’s estate.

Trait 5: The plan beneficiary has primary responsibility for distributions and transfers.

The original beneficiary may reduce the tax costs of future beneficiaries by carefully choosing the appropriate successor beneficiaries.  Some profit sharing or 401(k) plans may not allow all of the distribution alternatives permitted by the tax law.  After retirement or a separation from service, the original beneficiary in those cases may be able to transfer his or her retirement interest to an IRA that would not limit distribution alternatives.

The retirement account beneficiary normally owns other assets in addition to the retirement plan, even though the retirement plan may be the person’s largest asset.  In some cases, it may be possible to leave the retirement plan interest in the most advantageous tax manner possible and use the other assets to accomplish a person’s other estate planning goals.

In a future article, we will discuss a few specific situations and possible tax planning alternatives.

This article discusses the general rules applicable to retirement plans. It does not go into all of the special rules or exceptions that could apply in specific situations. Also, the terms of a specific retirement account will affect its taxation. Accordingly, please talk to a qualified advisor about the specifics of your situation to identify the planning opportunities available to you.