Maximizing Tax Benefits of Retirement Assets
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Top Tips in Ten Minutes
Maximizing Tax Benefits of Retirement Assets
Sara A. Nicholson, Warner Norcross + Judd LLP; Nancy H. Welber, Nancy H. Welber PC

With a high estate tax exemption and portability, clients can maximize the income tax benefits of retirement benefits without estate tax consequences. Use these tips to advise clients on beneficiary designations and distributions from retirement plans.

Tip 1:  Separate rollovers from employer plans for asset protection
Counsel clients rolling over an account from an employer-sponsored plan into an IRA to establish a separate IRA for the employer plan benefits, including 401(k) and 403(b) plans. Do not roll over funds from an employer plan to an IRA that already has contributions made directly by the owner, whether the contributions were deductible or nondeductible. Moreover, the client should not make additional contributions directly into an IRA containing only funds rolled over from an employer plan. If possible, capture the employer plan benefits as a rollover IRA, with “rollover” in the account title, to distinguish it from the client’s contributory IRA. Mixing benefits rolled over from employer plans and contributory IRAs results in the IRA’s losing superior creditor and bankruptcy protections afforded to employer plan accounts and IRAs consisting only of employer plan benefits rolled into the IRA. Due to the limit of creditor protection to one IRA under Michigan law, however, leaving retirement funds in an employer-sponsored plan where practicable still affords the most creditor protection.
Tip 2:  Consider the income tax consequences of deferring the first required minimum distribution
Generally, an owner of an account has until April 1 of the year following the year in which the person turns age 72 to take the first required minimum distribution (RMD), but must take the second RMD by December 31 of the year after the owner turns age 72. If the owner defers the first RMD to April 1 of the following year, they would then have two RMDs to include in that year’s income. An owner should project income expected in the year in which the owner reaches age 72 and the following year, to determine whether deferring the first RMD would be beneficial despite the double RMD in the second year. The owner may prefer deferral if the person expects less income in the second year. If the owner continues to work after reaching April 1 of the year following the year in which the owner turns age 72, they may be able to defer RMDs from the person’s employer plan, but not from traditional IRAs, until April 1 of the year following the year in which the person retires.
Tip 3:  Name the owner’s spouse as the sole, primary beneficiary
When an owner is married, naming the spouse provides the best income tax result. The spouse may roll the decedent’s account into the spouse’s IRA, instead of an inherited IRA. This allows for a more favorable RMD calculation and deferral of RMDs until the spouse attains age 72. It also allows the surviving spouse’s beneficiaries to stretch any remaining IRA over that beneficiary’s own life expectancy, instead of having to continue using the surviving spouse’s life expectancy to determine RMDs, as with an inherited IRA. Keeping the funds temporarily in an inherited IRA, however, may be preferable to rolling the account into the spouse’s own IRA for some. The inherited IRA allows spousal beneficiaries to defer RMDs until the year in which the deceased spouse would have reached age 72. In addition, if the surviving spouse is under age 59½ at the death of the owner, using an inherited IRA can allow the young spouse to take distributions following the owner’s death without incurring the 10 percent excise tax on early withdrawals. The surviving spouse can then roll over the account into the spouse’s own IRA after age 59½ or at any time after the owner’s death. Nontax factors may favor naming a nonspouse beneficiary, such as children in a second marriage or a desired charitable gift after the first death.
Tip 4:  Never name an estate or non-see-through trusts as a beneficiary
Estates, non-see-through trusts, and charities never qualify as a designated beneficiary. In addition, an estate, a non-see-through trust, and a charity cannot roll over an employer-sponsored plan into an inherited IRA to take advantage of what are often much longer payout periods than the employer-sponsored plan allows. Therefore, an owner should almost never name an estate or a non-see-through trust as a beneficiary, but rather should name the individuals or charity directly or consider a carefully drafted trust. While naming individuals as beneficiaries directly usually provides better income tax deferral than a trust, a trust may be the better option for nontax reasons, such as a beneficiary receiving government benefits, minor beneficiaries, second marriages, or other situations. However, if charities are to be trust beneficiaries, very careful drafting is required to be sure the trust may ultimately qualify as a see-through trust.
Tip 5:  Fix undesirable beneficiaries by September 30 of the year following death
All beneficiaries on an account must be designated beneficiaries to qualify for the life expectancy payout method. If a nondesignated beneficiary remains at the September 30 deadline, designated beneficiaries on the same account cannot use the life expectancy method. Therefore, purge all nondesignated beneficiaries by September 30 of the year following the year of the owner’s death.
A charity or other nondesignated beneficiary can liquidate its interest so that it does not disqualify any designated beneficiaries on the same account from using the life expectancy payout method. Consider creating a separate IRA during the owner’s lifetime for all charitable beneficiaries, to eliminate the possibility that a charity does not liquidate its share before the September 30 deadline and disqualify other designated beneficiaries from stretching their shares.
Named beneficiaries may also consider disclaiming their interest to allow it to pass to different beneficiaries. The disclaimer must be a qualified disclaimer under IRC 2518, and in most instances must be completed within nine months of the owner’s death. The disclaimed interests will pass to the secondary beneficiaries, if any. If none, consult the plan document or IRA agreements to determine whether the account passes to the owner’s heirs-at-law or estate.
Tip 6:  Fix trusts that do not qualify as see-through trusts
It is possible to “fix” trusts that may not qualify as a preferential see-through trust by the September 30 deadline by cashing out “undesirable beneficiaries,” through disclaimers by beneficiaries, or by disclaimers or releases of fiduciary powers, including powers held by trust protectors. Identify potential problems with trusts long before the September 30 deadline. The fixes for trusts are often more challenging and time consuming to make than a retirement account that is payable outright to beneficiaries, whether individuals or charities.
Tip 7:  Create separate accounts for multiple beneficiaries
Multiple designated beneficiaries on an account can create separate accounts by December 31 of the year following the year of death to calculate RMDs based on each beneficiary’s own life expectancy. However, separate accounts should ideally be created by September 30, the date when the beneficiaries are fixed for determining (1) whether all beneficiaries are designated beneficiaries and (2) the calculation of the applicable distribution period for the required minimum distributions (whether subject to the life expectancy method or the 10-year rule under the Setting Every Community Up for Retirement Enhancement Act). Separate accounts particularly benefit younger beneficiaries who qualify as eligible designated beneficiaries and can stretch the account for a longer period of time and surviving spouses who have more favorable options under the minimum distribution rules. If the multiple beneficiaries named in a beneficiary designation fail to establish separate accounts by the December 31 deadline, the RMDs will be based on the life expectancy of the beneficiary with the shortest life expectancy.
The “separate account rule” generally does not apply to trusts, except for conduit trusts, that must take effect at the death of the account owner. Therefore multiple outright beneficiaries of a trust will use the life expectancy of the oldest beneficiary if all trust beneficiaries are individuals.
Tip 8:  Roll over an estate or trust’s account to the surviving spouse if the spouse is the sole fiduciary and beneficiary
The decedent may have named a trust or the estate as the beneficiary of an account instead of the surviving spouse individually. But if the surviving spouse effectively fully controls that trust or estate as the sole fiduciary and is the sole beneficiary, the surviving spouse may be able to roll over the account into the spouse’s IRA. The beneficiary designation may have been structured this way due to client error, because of changes in tax laws since the estate plan was last revisited (e.g., at the time the designation was recommended, the client’s estate was taxable and the account was needed to fully fund a credit shelter trust), or maybe as a result of the attorney’s poor advice due to unfamiliarity with RMD rules on inherited accounts. Multiple IRS rulings permit spousal rollovers in similar instances, and some custodians will agree to treat the spouse as the beneficiary, thus allowing the beneficial spousal rollover. Others will allow the spousal rollover only with an opinion letter from counsel citing some of the private letter rulings. Still other custodians will require a private letter ruling to enable a spouse to roll over the IRA in this situation. In that case, consider a trustee-to-trustee transfer to a “friendly” custodian that will allow the rollover without a private letter ruling or an opinion letter. Note that the IRS has made it clear that it will not honor other trust or beneficiary designation reformations that only generate tax benefits, if there is a problem with the trust or beneficiary designation that does not allow this simpler spousal rollover to apply.
Tip 9:  Defer, or stretch the payout of a Roth account after death
Roth IRAs are not subject to the RMD rules during the owner’s lifetime, but the nonspouse beneficiary must take RMDs after the owner’s death. Assuming the Roth account was established for at least five tax years, withdrawals from a Roth account are not taxable because those funds were contributed post-tax. Thus liquidating an inherited Roth account, instead of stretching withdrawals over the beneficiary’s lifetime, does not incur the same tax liability as an account consisting of pretax dollars, such as a 401(k). However, Roth accounts still offer tax-free growth. So long as the funds remain in the Roth account, any appreciation or income earned escape income tax entirely. The longer a beneficiary can keep funds in the Roth account, the more tax-free appreciation and income will grow. Once the funds are removed from the Roth account, any growth or income on those investments is taxed at the beneficiary’s applicable income tax rate.
Tip 10:  Change custodians or transfer the account over to an IRA if necessary to maximize deferral
The RMD rules determine the slowest possible payout of accounts, but a plan can require a faster payout. For example, many qualified plans require a lump-sum distribution to any nonspouse beneficiary after death, even if the RMD rules permit a five-year, or longer, payout. Designated beneficiaries may transfer that account into an “inherited IRA” to maximize the payout available under the RMD rules. In addition, some custodians, even IRA custodians, may balk at taking certain steps to help a beneficiary maximize the available stretch. Examples of tasks that some custodians have hesitated to perform are creating separate accounts for beneficiaries to allow each to use his life expectancy to stretch the account, or allowing a spousal rollover from an estate or trust. If a custodian hesitates to cooperate to allow the best treatment available to the beneficiaries under the RMD rules, consider using a trustee-to-trustee transfer to transfer the account to a different custodian that is more accommodating.
Tip 11:  Include language in the client’s durable power of attorney specifically addressing retirement accounts
The account custodian or plan administrator may refuse to work with the owner’s agent under the owner’s durable power of attorney if the document does not specifically include management of retirement accounts under the agent’s powers. At a minimum, the power of attorney should permit the agent to access account information. Ideally, the power of attorney should specifically permit the agent to accomplish a variety of enumerated tasks, including establishing or contributing to various types of accounts, taking distributions regardless of the tax consequences, and making benefit elections, rollovers, and trustee-to-trustee transfers. Additional possibilities include the power to borrow from any employer plan that allows borrowing. If desired, the document should explicitly include the power to make or change beneficiary designations. If the power of attorney explicitly grants the agent the power to name him- or herself as beneficiary, safeguards should be considered to prevent abuse. You may also consider using the custodian’s own form to ensure that the custodian will accept it. If used, you should review the form yourself and revise the client’s general power of attorney so that it does not revoke or conflict with the custodian’s power of attorney.
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