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Home arrow H&B News arrow How Do IRA And 401(K) Plans Fit Into An Estate Plan?
How Do IRA And 401(K) Plans Fit Into An Estate Plan? Print E-mail

May 2010

n preparation of Wills and Trusts for clients, consideration of what to do about IRA and 401(k) accounts may be overlooked.  Like life insurance, these investment vehicles do not pass to beneficiaries by Will and cannot be held in a grantor trust prior to the death of the account holder.  Upon death of the holder, the contract establishing the IRA or 401(k) determines who will receive the proceeds.

There are significant tax implications depending on the choice of beneficiaries.  Where a beneficiary dies before receiving any required distributions from an IRA or 401(k), the beneficiary’s entire interest must be distributed within five years after his death except where the beneficiary's interest: (1) is distributed over the life of a designated beneficiary (or over a period not extending beyond the life expectancy of the beneficiary) and the distributions begin no later than one year after the date of the beneficiary’s death (Code Sec. 401(a)(9)(B)(ii), Code Sec. 401(a)(9)(B)(iii)), or (2) is distributed over the life of the surviving spouse (or over a period not extending beyond his/her life expectancy), and the distribution begin no later than the date on which the beneficiary would have reached age 70 1/2. If the surviving spouse dies before payments must begin, then the 5-year rule applies as if the surviving spouse were the employee. Since an estate or a trust does not have a life expectancy, the above described exceptions do not apply and then the entire corpus of the IRA or 401(k) is subject to tax over a five years period.    However, if the beneficiary is a person (likely to be in a younger generation) his or her life expectancy would be longer and the resulting payout period would be extended thus enabling the funds to be retained, tax free, to grow over the additional time available.  Further, if the beneficiary is entitled to name successor beneficiaries, the effect can be material in terms of earnings during their lifetimes. 

The potential importance of these considerations is shown by an example published in the AARP March & April 2010 magazine at pages 25-26.  In the example, an IRA containing assets valued at $400,000 on the date of death are left to a 40 year old daughter, whose life expectancy was then 43.6 years.  Her initial withdrawal would be $9,174 and would be taxable.  However, the IRA balance would grow, possibly at 12%, to something in the range of $1.2 million by the time she is 65 (and she would have drawn out $671,000).  Obviously, such sums greatly exceed what would be received if the IRA had to be paid out (and taxed) over 5 years or over the much shorter life expectancy of the deceased holder.

Not every client has a primary concern to defer taxes and some may be more concerned with placing valued assets under the immediate care of a trustee to protect interests of certain beneficiaries or even future generations.  But, it is clear that this issue needs to be addressed during the estate planning process and resolved in a way that meets the client’s informed preferences.

© 2010 Hughes & Bentzen, PLLC.

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