When a person dies that person’s property is divided into two primary categories- probate assets and non-probate assets. Probate assets are those that typically pass to beneficiaries by way of a person’s last will and testament. Non-probate assets are those that pass by beneficiary designation. A typical example of a non-probate asset is a person’s retirement fund whether it be an IRA or 401k plan. Most people designate a primary beneficiary such as their spouse and contingent (or secondary) beneficiaries such as their children to these types of assets. And still others unwittingly name their estate as a primary beneficiary of their retirement assets.
Not understanding the effects of such designations can lead to disastrous results. Under the Internal Revenue Code only an individual (i.e. a human being) can roll over inherited retirement funds and stretch out the period of time before mandatory distributions must commence, which in most cases occurs at age 70½. This is commonly referred to as the “stretch out” period. The benefit of rolling over and stretching out retirement assets allows them to grow in a tax deferred environment for the longest period of time allowed under law. If, for example, you have named your estate as the beneficiary of your retirement plan those funds must be paid out during the five year period following your death to the residual beneficiaries named in your will. This is because your estate is not an “individual.” When non-individuals are named as the beneficiary of retirement funds, those funds must be paid out in the five year period commencing on the date of the account holders death. This is commonly referred to as the “five year rule.”
So what’s wrong with receiving all of the decedent’s retirement assets within the five year period? Remember that income taxes on retirement account assets were deferred. However, when the benefit is paid out it is counted as taxable income to the beneficiary who receives it. For example, husband dies with a 401k containing $500,000. Husband named his estate as beneficiary of the 401k. Husband’s last will leaves everything he owns at the time of his death to his wife. Wife must receive the $500,000 within the next five years following her husband’s death. Let’s say that wife takes $100,000 per year for five years. Each $100,000 yearly distribution is considered income to wife and subject to federal and state income taxation. Maybe wife did not need the $500,000 at this time as she is gainfully employed. Or maybe wife did not want to have this amount counted against her for financial aid purposes concerning her children nearing college age. Could be that wife has creditors, or even worse a potential plaintiff breathing down her neck and did not want to put those assets on the table. Or maybe wife simply wanted to continue to enjoy the benefits of those assets growing in a tax free environment. As you can see there are many good reasons to consider availing yourself of the stretch out.
What does your estate plan have to say about how your retirement assets are distributed at your death? Have you named your estate or a living trust as the primary beneficiary of your 401k or IRA? We just talked about the potential negative consequences of naming your estate. But what about naming your living trust as beneficiary? A living trust is not an individual. However, there are special provisions that can be written into your trust that will cause the IRS to look through the trust to the individual beneficiaries to overcome the five year rule. These special provisions are called conduit provisions. This is very complex area of law and is beyond the scope of this blog post. The point is that you need to review your estate plan with an estate planning attorney as circumstances change in your life.
Put your mind at ease and call the Perna Law Firm today for a free consultation. Let us help you protect your family and your financial interests.