Timely Tax and Estate Strategies for Retirement Plans

Journal of Financial Planning; October 2014


Philip Herzberg, CFP®, CTFA, AEP®, is a relationship manager for United Capital Financial Advisers, LLC in Boca Raton, Florida. He is president-elect of FPA of Florida, chairman of FPA of Miami, and a member of the Estate Planning Council of Greater Miami Board of Directors.

Current tax and estate planning may be especially challenging when it comes to passing assets held in Individual Retirement Accounts (IRAs) and qualified plans, which can make up a significant portion of your clients’ wealth. How your clients’ IRAs are distributed to their heirs is stipulated by beneficiary designation forms provided by their IRA custodian—not by their trust or will. 

As a planner, what techniques can you employ to help clients protect and manage their assets? Assess the following suitable pointers in accordance with your clients’ estate planning intentions and income tax minimization goals.

Prudent Inherited IRA Strategies

Carefully review your clients’ IRAs and beneficiary designations in light of a June 12, 2014, federal decision that places inherited IRAs into the hands of creditors in the event of bankruptcy (unless there is a separate state law providing such protection). Be knowledgeable that inherited IRAs do not permit contributions, have ongoing distribution requirements, and carry no early withdrawal penalties.

Working in tandem with tax advisers and estate planning practitioners, you can inform spousal beneficiaries that they can roll over inherited retirement accounts into their own name, rather than leaving them as inherited IRAs. The flexible use of this option is pivotal for income tax deferral planning, as the surviving spouse possesses all of the tax-deferred growth opportunities that would have been available during the participant’s lifetime. Note that spousal heirs have the right to defer withdrawals from a pre-tax account until they themselves turn 701/2, or from a Roth account until after their death.

Know that many of your clients choose to leave IRAs or Roth IRAs to their surviving spouses who are likely to need the money much sooner than children or grandchildren. Should your clients’ surviving spouses not need the money, they can disclaim the IRA to whoever was named as contingent beneficiaries, usually their kids or grandkids. 

Unlike the majority of their inheritances, your clients’ beneficiaries may be subject to estate taxes and will currently pay income tax on the annual distributions they receive from the inherited IRA. Be sure to educate non-spousal heirs to properly retitle the IRA as an “inherited IRA.”

IRA planning can be even more difficult with remarried clients who have blended family members. Be wary that spouses who inherit IRAs can subsequently change successor beneficiaries to support their own biological kids rather than your clients’ children.

In concert with the guidance of an estate planning attorney, you can decide to have your clients withdraw their qualified plan or IRA balance prior to death. Although this strategy sacrifices all income tax deferral, it can still be considered in appropriate cases for all clients. Think about leveraging this technique if a large portion of the IRA will have to be liquidated immediately after death to meet estate cash requirements, or if the distribution of a qualified plan balance is unavailable for other reasons.

Trusts as Beneficiaries to Protect Heirs

Are your clients worried about their adult children blowing through their inheritance? Designating trusts as beneficiaries of their IRAs may be viable to those clients seeking to utilize trusts to help minimize estate taxes or to protect susceptible beneficiaries, such as your minor grandkids or children at risk of getting a divorce. Do not have your clients name their estate as beneficiary.

In many cases, trusts as beneficiaries of IRAs that do not comply with Internal Revenue Service rules end up being disqualified with all the account funds having to be distributed to your clients’ beneficiaries within five years of the owner’s death. To avoid disadvantageous income tax treatment, it will still be vital that the trust as beneficiary is devised in a manner that complies with the requirements of Treasury Regulation 1.401 (a)(9)-4, Q&A-5, so that the trust can stretch distributions from the inherited IRA over the life expectancy of underlying beneficiaries (for more information, see Michael Kitces’ 2014 article “An Inherited IRA is Not a ‘Retirement’ Account for Bankruptcy Protection Under Clark v. Rameker Supreme Court Case” at Kitces.com).

Be aware that clients may still have rollover options if a trust has been named as the beneficiary of a qualified plan or IRA. Enlist the expertise of an estate planning lawyer to fully review the terms of the governing instruments and verify if the clients’ spouses can qualify for a rollover.

In collaborating with legal professionals to administer trusts that are designated as beneficiaries of qualified plans or IRAs, you may be able to prevent the unnecessarily quick distribution of the retirement plans by completing estate administration duties within nine months after your clients’ death. 

Alternatively, you can have clients use a “trusteed IRA,” where the IRA provider serves as trustee and distributes the IRA assets to beneficiaries as directed by the original owner. Employ specific provisions to protect a spendthrift child from cashing out the entire IRA and allow the trustee to make only the required annual minimum distributions. Note that trusteed IRAs usually have significantly higher minimum balance requirements and fees than regular IRAs.

Roth IRA Conversions and Planned Charitable Bequests

Consider converting all or part of a traditional IRA to a Roth IRA if your clients expect to have a taxable estate or do not need cash for living expenses. Know that the money your clients pay in conversion income taxes reduces their estates, which could lower estate taxes.

In addition to its estate planning benefits, a Roth IRA conversion may make sense for clients who are projected to be paying income taxes at a higher rate in the future than they are now. Be cognizant of potential changes in tax laws, including legislative proposals aimed to eliminate the option of beneficiaries of inherited IRAs spreading payments out over their expected life spans.

Most importantly, tax-deferred retirement plans can leave your clients’ heirs with assets receiving no step-up in basis. Remember that non-retirement assets get a step-up in basis at your clients’ death, but heirs have to pay ordinary income tax on withdrawals from a traditional IRA.

Realize that your clients have a planning opportunity if they desire to leave money to both loved ones and a charitable organization. Your clients can concurrently bequest their traditional IRAs to charities and leave their non-spousal heirs a Roth IRA or assets from taxable accounts.

Effective coordination with credentialed tax and estate specialists is pivotal to facilitate continuous planned giving strategies for your clients and their families.

Estate Planning
Retirement Savings and Income Planning
Tax Planning
Professional role
Tax Planner