Estate Planning with Qualified Accounts
What are qualified accounts?
Qualified accounts are retirement-type investment accounts that receive preferential income tax treatment. Income taxes on qualified accounts are generally tax deferred, which results in taxes that are not paid until funds are withdrawn from the account (however, Roth accounts are an exception because Roth withdrawals are generally not taxed upon distribution).
What are the different types of qualified accounts?
Different types of qualified accounts include Individual Retirement Accounts (IRAs), 401k, and 403b. These accounts are able to avoid probate because they allow a beneficiary to be named when the account is established. Employer-sponsored retirement accounts like 401k’s should automatically have your spouse named as the primary beneficiary, and if you want to change that then you will need him or her to sign a spousal waiver in front of a notary. When distributing proceeds of qualified accounts to the beneficiary(s), it is a similar process as life insurance where the beneficiary simply calls up the custodian and has them rollover or transfer the assets held in the qualified account.
What does this mean for my estate planning?
When considering how to handle the different types of qualified accounts from an estate planning perspective, you have to consider both the tax consequences and the hassle-factor associated with the account.
For example, from a practical perspective, it is generally easiest to keep your spouse named as the primary beneficiary on the accounts and your children named as the contingent or secondary beneficiary (per stirpes). By doing so, your spouse will have the preferential treatment to rollover the qualified account into his or her own account (i.e., the surviving spouse can consolidate assets) whereas a child or other non-spouse beneficiary will have to deal with the inherited qualified account rules - which generally require the entire amount to be withdrawn within 10 years (which may or may not have a substantial income tax impact on your beneficiaries). The interesting thing about qualified accounts is that they don’t receive a step-up in basis, whereas a non-qualified account (for example, your typical taxable brokerage or non-retirement investment account) would get the benefit of a stepped-up basis in assets under current law (this may or may not change in the future). A stepped-up basis means that the cost basis of the investment is adjusted to its fair market value on the date of your death. So, as you may be able to imagine, if you had an investment that you originally purchased for $10,000 in the early 1990s, that is now worth close to $100,000 because of appreciation over the years, then that stepped-up basis could mean the difference between paying an income tax on a $90,000 capital gain vs. paying no income tax at all.
This is why you need to work with both your financial advisor and your estate planner to determine the best “asset location” of your investments when considering the income and estate tax implications.
Things get tricky when you don’t want to leave a qualified account outright to your spouse or other beneficiaries. For example, if you prefer the money is held in a trust for the benefit of your spouse during her life (commonly structured as a QTIP trust), then you need to make sure the trust is properly named and other provisions of the trust qualify it to receive such property without negative income tax implications. Most custodians are experienced with such matters, but this can certainly be a confusing process for the spouse and may require a lot of paperwork on the backend for your financial advisor. Unless you are concerned about remarriage risk, it is almost always better to just have your spouse named directly as the primary beneficiary on your retirement account. The same goes for leaving qualified accounts to children because of the withdrawal rules. Therefore, many of my clients forgo the hassle of naming the trust as a beneficiary of their qualified account unless their children are minors, financially inexperienced, disabled, or have some other underlying situation that would make an outright distribution undesirable to the grantor.
If you have any questions about how your qualified or retirement accounts fit in with your overall estate plan, then please give me a call at (781) 202-6368 or email me at JLento@PerennialTrust.com - I’m always happy to answer your questions.
Sincerely,
Joseph M. Lento, J.D.
Attorney & Owner of Perennial Estate Planning
Other helpful readings:
Carlson, Darren R. (2014). Your 1960S Tv Guide To Estate Planning. MOTIVATIONAL Press, INC.
Fontinelle, A. (2017, March). Early retirement tips for avoiding penalties | MassMutual. Mass Mutual. https://blog.massmutual.com/post/retire-early-avoid-penalties
