Retirement Accounts and Income Taxes vs. Estate Taxes

The Family Trust, as contained in a Will or Living trust, is designed to hold assets of the first spouse to die, up to the amount of the federal estate tax exemption (currently $2 million). It provides support to the surviving spouse, and when the surviving spouse dies, the value of the Family Trust is not included in his or her taxable estate. This plan can save $1 million or so in estate taxes for couples with estates of $4 million and up.

Because of the fact that income taxes have to be paid on distributions from a retirement plan, funding a Family trust with a retirement plan, while advantageous from an estate tax standpoint, can be disadvantageous from an income tax point of view.

If estate taxes are not an issue, the best way to handle a retirement plan is to leave it outright to a spouse, who can then roll it over into an IRA. The spouse can then name the children to received the account at his or her death, and the children can use their life expectancies to take distributions, allowing a “stretch” of the benefits. This allows more tax-deferred growth.

However, if estate taxes are an issue, it is often advisable to have the retirement account paid to the Family Trust, which will allow the account to escape estate tax at the surviving spouse’s death. If the trust is designed properly, the survivor’s life expectancy is used for purposes of taking distributions, and after the survivor dies, the children will receive the retirement benefits. However, since the trust owned the account rather than the surviving spouse, no further stretch is allowed, so the children must take out distributions over the deceased spouse’s remaining life expectancy per IRS tables. (e.g., at age 80, 10 more years or so, as opposed to about 35 years for a 50 year old child.) This means that the income taxes must be paid over a much shorter time period and not as much tax-deferred growth can occur.

The loss of tax-deferred growth is generally worthwhile, however, since the estate tax rate is about 50%, when NC estate tax is added to the 45% federal rate.

 In addition to arranging the beneficiary designation correctly, the Family Trust must include special provisions to help ensure the best income tax treatment for retirement plans payable to the trust.

What I advise many clients to do is name the spouse as the first beneficiary, the Family Trust as the second beneficiary, and the children, or their trust shares, as the third beneficiary. At the time of the first spouse’s death, the survivor can then decide which option makes the most sense at that time, based on the current value of the couple’s assets and the tax laws then in effect. In the event of simultaneous death, the children will be able to avail themselves of the stretch based on their ages.

For large retirement accounts, over $200,000 or so, I generally recommend a Standalone IRA Trust, which can be used for IRAs and other retirement plans.

This is a very complicated area of the law, so you should always consult an estate planning attorney to determine the best way to structure your retirement account beneficiary designations.