Mat Sorensen


August 20, 2013

When an owner of a retirement account passes away, their retirement account is passed on to the heirs of that account as they are designated on the account owner’s beneficiary designation form. The taxation and distribution rules are different depending on whether the beneficiary of an account is a spouse or a non-spouse beneficiary. If the beneficiary is a spouse, there are additional tax deferral options. The recently enacted Pension Protection Act took effect a few years ago and significantly changed the rules with respect to taxation and distribution of retirement accounts. Please find a summary of the new options below.

Stretch Option only for Spouse

1. Stretch Option. A spousal beneficiary has the most opportunity to continue to defer payment of tax since a spouse can roll their deceased spouses account over to a new or existing IRA in the surviving spouse’s name. If the surviving spouse has not yet reached the date by which he or she is required to take distributions from the IRA account (age 70½), the assets can remain in the account and can continue to grow tax-deferred until the surviving spouse reaches 70½. If the surviving spouse is years away from age 70½ , naming the spouse as a beneficiary is the best strategy to take advantage of the continued tax deferral because you delay the payment of tax and can continue with tax deferred growth until the surviving spouse reaches age 70½.

Options for All Beneficiaries

1. Disclaim the IRA. Any beneficiary can disclaim his or her interest in the deceased persons retirement account and thereby pass the account to secondary beneficiaries who may be in a lower income tax bracket. This may be beneficial to a surviving spouse who is already 70½ and cannot stretch out the tax deferral benefits of the account and who is also in a high income tax bracket. By disclaiming the account interest, the account would go to the secondary beneficiaries (typically children) who may be in a lower income tax bracket.

2. Lump Sum. Any beneficiary can take a lump sum distribution from the account free of penalty but if you take a lump sum distribution you will also take a lump sum tax bill.

3. Five Year Rule. Any beneficiary can take distributions from the retirement account over a five year period. This is beneficial because it allows for continued tax deferral over a period of five years and will help a beneficiary avoid taking a large lump sum distribution which will likely push that beneficiary into a high income tax bracket.

4. Life Expectancy Rule. This option is available when the retirement account holder passes away before he or she reaches age 70½. A beneficiary may take distributions from the retirement account based on the life expectancy of the inheriting beneficiary. If the inheriting beneficiary is younger in age the inheriting beneficiary will be able to maximize tax deferral over a longer period of time because the IRS gives them longer to live and therefore more time to make distributions. If the beneficiary is older in age, the IRS will require larger yearly distributions to make it more likely that the funds will be distributed over the inherited beneficiary’s life time.

See Through Trusts

The IRS has indicated that a “see through” trust may be named as a beneficiary of the retirement account and the IRS will “see through” the Trust itself directly to the Trust’s beneficiaries. Because Trusts pay taxes at higher rates than individuals, we need to make sure that the Trust is considered “see through” so that the account may pass directly through the Trust to the beneficiaries. The requirements of a “see through” Trust are as follows:

1. Trust must be valid under state law;

2. Beneficiaries must be determined from the Trust;

3. The Trust must be irrevocable or become irrevocable at the death of the retirement account owner;

4. Documentation of your trust must be provided to your plan administrator;

5. All Trust beneficiaries must be individuals.

If you are uncertain as to whether your Trust qualifies as a “see through” Trust, please contact the law firm for an analysis. If your Trust requires an Amendment so that it qualifies as a “see though” Trust, we can prepare an Amendment to the Trust.

When naming beneficiaries to your retirement accounts, we typically recommend that you name your spouse as a beneficiary first (if you have one) and then your “see through” Trust or your children second. There are some important estate planning considerations here when naming a trust so make sure you consult with a competent attorney.

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