March 17, 2004

Planning for Retirement Accounts: There Is More to Consider than Asset Allocation

Holland & Knight Newsletter
Scott Johnston

Given the benefits of pre-tax contributions and tax-deferred growth, retirement accounts have become the largest repository of liquid assets for many Americans. This fact alone would make planning for the disposition of retirement accounts a key part of most estate plans. When you consider that retirement accounts may be subject to combined federal estate and income taxes of approximately 70 percent at the time of the death of the plan participant, the motivation for proper planning is truly compelling.

Most people hurriedly complete beneficiary designation forms with little or no consideration of their options and the consequences to their estate plans. Fortunately, beneficiary designations are revocable, providing participants with an opportunity to revisit these options with greater focus when reviewing their overall estate plans.

Types of Retirement Accounts

There are many forms of retirement accounts. The most common include IRAs, 401(k)s, profit sharing plans and Roth IRAs. Roth IRAs are fundamentally different in that after-tax dollars are used to fund them and thus there is no deferred income tax liability. Consequently, they are largely excluded from this discussion.

Consequences of Distributions Before and After Required Beginning Date

In most cases, and with certain exceptions, withdrawals made by a participant before attaining age 59½ are subject to a 10-percent penalty in addition to income taxation as ordinary income. These exceptions include distributions due to the death or disability of the participant, distributions from IRAs for certain medical and educational expenses, and up to $10,000 for the purchase of a first home. After attaining age 59½, a participant may start to withdraw funds without penalty.

Minimum required distributions must commence by the “required beginning date” or else an excise tax will be imposed equal to 50 percent of the minimum required distribution, reduced by any actual distributions made during the year. Generally speaking, the required beginning date is April 1 of the calendar year following the year in which the participant attains the age of 70½. However, participants in a qualified plan (which does not include IRAs) who do not have a five-percent ownership interest in their employer and continue to work after attaining 70½ can defer the required beginning date until the time of their retirement. See the next story, Calculating Minimum Distributions, for guidelines.

There is no required beginning date for Roth IRAs. For estate planning purposes, withdrawals from Roth IRAs should be deferred as long as possible and should not be withdrawn until other retirement plans have been fully distributed.

Generally, minimum required distributions are calculated based upon the participant’s life expectancy. For an inherited IRA, however, minimum required distributions are based on the life expectancy of the designated beneficiary.

Some retirement plans do not permit the beneficiary to defer distributions from the plan once the required time for distribution is reached. In such cases, if allowed, rollovers to IRAs should be considered which would defer the income taxation of the amount distributed and would permit the use of several of the beneficiary designation planning options discussed below.

Beneficiary Designations

Spouse. For married couples, a spouse is certainly the most common beneficiary of a retirement account. In fact, for most plans other than IRAs, a spouse is required to sign a waiver if he or she is not designated as beneficiary. A spouse has the unique advantage of being able to roll over the deceased spouse’s IRA and treat it as his or her own. This permits the surviving spouse to defer withdrawals and continue tax-deferred growth of the account until the survivor attains age 70½. It also gives the survivor the opportunity to designate new beneficiaries. The assets of the IRA will be included in the surviving spouse’s estate and may be subject to estate tax at the time of his or her death.

Children and Grandchildren. A designated beneficiary other than a spouse may take required distributions in annual installments over the period of his or her life expectancy. Thus, the beneficiary is able to defer income taxes on the distributions from the retirement account. The benefit of tax deferral will depend upon the age of the designated beneficiary. The fair market value of the retirement account will be included in the deceased account holder’s estate and may give rise to estate taxes. Consider the allocation of such estate taxes when preparing your estate plan. An income tax deduction for the estate taxes may be available to the beneficiary.

While grandchildren may be excellent beneficiaries because they are in a position to defer income taxes on retirement accounts for a long time, take care to insure that amounts passing to grandchildren do not exceed the available amount of the participant’s generation-skipping transfer tax exemption.

Charity. For the charitably inclined, designating a qualified charity as beneficiary of a retirement account can be a “win-win” situation. The individual’s estate receives a charitable deduction against estate taxes and the charity does not have to pay the deferred income taxes embedded in the account.

Instead of naming a charity as an outright beneficiary of a retirement account, consider designating a charitable remainder trust as beneficiary. This approach may provide a flexible alternative in situations where the ultimate beneficiary is the result of a spousal disclaimer, as discussed below. Such an approach can provide the spouse or other family members with a lifetime interest in the retirement account. The charitable beneficiary may be a family or community foundation.

Trusts. With retirement accounts representing a greater percentage of decedent’s estates and the recently enacted estate tax exemptions increasing to as much as $3.5 million, it may be desirable in some estate plans to use retirement accounts to fund bypass trusts. Such trusts are designed to fully utilize the decedent’s estate tax exemption. Note, however, that retirement accounts are not the ideal asset to fund bypass trusts, since the amount ultimately passing to the remaindermen free of estate tax will dwindle as the account is depleted by required minimum distributions.

A participant may file a beneficiary designation naming his spouse as the primary beneficiary and, if the spouse disclaims such property, the trustees of the bypass trust created under his will as the alternate beneficiary. In this way, the surviving spouse can determine whether the benefits of fully funding the bypass trust outweigh the related costs based upon the nature and extent of the decedent’s estate and the applicable estate tax exemption at the time of his death.

There are several requirements that must be met if a trust is to be named as designated beneficiary:

  • the trust must be valid under local law
  • the trust must be irrevocable, or become irrevocable upon the death of the participant
  • the beneficiaries must be identifiable individuals, and
  • a copy of the trust instrument or summary of its terms and a list of the trust beneficiaries must be supplied to the plan administrator on or before October 31 of the year following the participant’s death

Estate. Generally speaking, it is not wise to designate your estate as beneficiary of your retirement account. Such action will rob the ultimate beneficiary of the opportunity to receive distributions based on his or her life expectancy and could result in a loss of the resulting income tax deferral. It may also increase costs associated with having a larger probate estate.

No Designated Beneficiary. If an account holder fails to designate a beneficiary, most retirement plans contain default provisions. However, given the significant costs and benefits associated with the various beneficiary designations noted above, no participant should leave the selection of beneficiaries to chance.

Registering Beneficiary Designations with Custodians

As discussed above, well-considered beneficiary designations may involve more than naming a spouse as the primary beneficiary and children as alternates. However, the beneficiary forms provided by plan administrators often do not accommodate more sophisticated options. In such instances, it is advisable for the plan participant to consult with an attorney and prepare a customized beneficiary designation.

It is also essential that plan participants obtain a copy of all beneficiary designations filed with the plan administrator and maintain a copy in their financial records.

Use of Disclaimers

As noted above, disclaimers may be contemplated in beneficiary designations in order to provide the flexibility needed to meet changing circumstances. Disclaimers should also be considered after the death of the participant if the designated beneficiary can achieve a more desirable outcome through their application. In order for a disclaimer to be effective, however, the disclaiming party must not have accepted any benefits from the account which extends beyond just the receipt of distributions. For instance, exercising control over the investments held in a retirement account will constitute acceptance of such benefits. Therefore, a designated beneficiary considering the disclaimer option should consult with an attorney in order to make certain that he or she does not inadvertently invalidate this option.


Given the uncertainties of the economy and, in particular, the viability of Social Security benefits, the continuing trend toward increased longevity and the benefits of tax-deferred growth, it comes as no surprise that retirement accounts have become the centerpiece of many financial plans. If not exhausted during retirement, the remaining assets held in such accounts can provide a significant legacy for family members and charitable causes. While beneficiary designation forms may not appear to be as complex or involved as your will or revocable trust agreement, looks can be deceiving.

Given the complex interrelationship between the income and transfer taxation of retirement accounts, such beneficiary designations can have a huge impact on the success of your estate plan and deserve special consideration.

Related Insights