Joseph Fabrizzio of Robson & Robson Joseph N. Frabizzio of Robson & Robson

As retirement approaches, a primary concern is most likely whether you have accumulated sufficient assets to provide for the life you envisioned after the end of your active career. For those who are fortunate enough to have a well-funded retirement, a secondary thought is what happens if my assets outlive me.

IRAs and other tax-deferred retirement accounts were designed to provide a means to allow individuals to increase their savings so that they can better support themselves when they are no longer working. By allowing tax-deferred growth over a period of many years and with some accounts permitting individuals to use untaxed assets to fund them, retirement accounts can grow at a more rapid pace than ordinary investments. At some point, however, the taxman cometh.

As a general matter, distributions from retirement accounts are taxed upon withdrawal. While there is a penalty for taking distributions too early, this penalty does not apply if you are over 59.5 years of age. However, after you turn 70.5 years of age, there is a penalty if you fail to withdraw at least a portion of your retirement assets in a given year. This amount is known as a required minimum distribution, or RMD, which is calculated based on the current life expectancy of the individual. Conceptually, delaying distributions until after retirement provides a tax advantage to retirees since most retirees will be in a lower income bracket than they were in during their highest-earning years. Since the undistributed accumulated funds in the account are able to continue growing while the individual is enjoying retirement, they are a great tool for retirement planning purposes. At the same time, mandating distributions beginning after you reach age 70.5 prevents these accounts from becoming a pure tax-deferred wealth transfer device.

Did I Really Name Him as My Executor?

As you near retirement, your financial adviser can assist you with calculating whether you have sufficient assets to provide for retirement. A good adviser also will suggest that you revisit your will and beneficiary designations on life insurance policies and retirement accounts. Families with young children often shuffle into their estate planning attorney’s office because someone told them they needed to check this item off their list. Decisions are made about guardians for the children, trustees for their minor children’s trusts and a host of other issues important to the new parents. Despite entreaties to revisit the plan every three to five years or upon major life events, most individuals place a check mark next to “estate planning” and promptly ignore the issues until they are triggered into action. This can happen when your children are about to get married, upon a divorce or when one of your children doesn’t turn out quite as expected. Executors die, relationships with siblings may lapse and the trusted friend at age 30 turns out to be someone who you now see in a different light. If none of these issues drove you to reevaluate your estate plan thus far, approaching retirement should provide an impetus to revisit your decisions.

Retirement Plan Assets Present a Unique Challenge

Because distributions from retirement accounts are taxed when withdrawn, the true value of the accounts to your beneficiaries may be less than what you expect. Consider a 75-year-old widow with $2 million in an IRA. Even after taking annual RMDs from the IRA, the tax-free growth in the account allows the principal amount to remain fairly stable. She may have visions of leaving $1 million to each of her two children by designating them as beneficiaries of her IRA. The result, however, may not be what she expected. Upon the widow’s death, her daughter decides to buy a new house and decides to take a lump sum distribution. Her son decides to travel the world and also chooses a lump sum distribution. Depending on the children’s income from other sources, they could each pay as much as $370,000 in federal income taxes on the distribution since it was all distributed within one calendar year. In addition, they would each pay another $45,000 in Pennsylvania state inheritance taxes. In one fell swoop, the gift of $1 million is reduced to less than $600,000. While still a substantial gift, the widow would likely be appalled to learn that her hard-won savings had been taxed at such a high rate.

Minimizing the Tax Bite

There are ways to avoid this result, but it involves either self-discipline on the part of beneficiaries or imposed discipline from the account owner. Enter the inherited IRA.

If the designated beneficiaries referenced above chose to take their distributions in the form of an inherited IRA, they may be eligible to use their own life expectancy to calculate the RMD they will need to take each year. This is referred to as the “stretch-out.” If the adult child beneficiary is significantly younger than the deceased parent, the child’s RMD will be a fraction of the amount the parent had to annually withdraw. The adult child can take out more than the RMD in a given year, but would ordinarily be subject to income tax on the entire amount withdrawn.

Note that there are potential problems with relying on individual beneficiaries to choose an inherited IRA and use it to their best advantage. You are depending on your beneficiary to make the decision to choose among a lump sum distribution, a distribution over up to a five-year period or a distribution over the beneficiary’s life expectancy. These choices must be made during the year after the account owner dies, so some beneficiaries are not in the best state to make this decision.

One option to avoid the aforementioned scenario is for the account owner to designate a trust to receive the IRA assets for the beneficiary. The terms of the trust and the appointed trustee will then control when money flows from the IRA to the trust and from the trust to the beneficiary. This takes the decision out of the hands of the beneficiary and places it in the hands of the trustee.

This option does require some careful thought.  In order for a trust to be considered as a “designated beneficiary” and qualify for the stretch-out treatment, the trust must meet a host of rules imposed by the Internal Revenue Service. The clearest path is for each beneficiary to have a separate trust, with each trust requiring the trustee to withdraw the RMD from the IRA each year and distribute it out the beneficiary. These trusts are known as conduit trusts and ensure that the intended beneficiary’s life expectancy is used to calculate the RMD.

It is also possible to draft the trust as an accumulation trust rather than a conduit trust. An accumulation trust is permitted to receive and hold the RMD in the trust rather than distribute it out to the beneficiary, but this approach requires careful planning to make sure that there are no other potential beneficiaries that would disqualify the trust from using the stretch out (such as charities or an estate) and no remainder beneficiaries who are older than the primary intended beneficiaries. These older remainder beneficiaries could result in a shorter life expectancy calculation, and therefore a faster required payout from the IRA, then intended. Because the trustee can be given the discretion to retain RMDs and other IRA distributions in an accumulation trust rather than distributing them out to the beneficiary, this type of trust can be beneficial when you suspect that the beneficiary may have future creditor issues, malpractice exposure or some other circumstance that suggests asset protection should be a consideration.

Note that leaving your retirement assets to your estate or failing to name a beneficiary forecloses the opportunity to maximize tax advantages for your beneficiaries.

Looming Congressional Action

Given the shifting political landscape, the planning opportunities explained above may become subject to further limitations.

A bipartisan bill recently reintroduced in the U.S. Senate, the Retirement Enhancement and Savings Act (Senate Bill 2526) could challenge the methods that advisers use to help their clients. The act was introduced in March 2018 and referred to the Committee on Finance. This legislation is a revised version of a similar bill introduced in 2016, passed out of committee and left dormant when the Senate adjourned. While there are some positive aspects to the act, its impact is detrimental to those individuals leaving large retirement accounts to their beneficiaries.

The act, as currently drafted, would limit the aggregate amount of IRA and defined contribution plan accounts that could be distributed under the stretch-out rule. Any amount in excess of the proposed amount, $450,000, would need to be distributed to beneficiaries within five years. We will need to keep an eye on this proposal and determine how and if it will impact planning for retirement accounts.

Joseph N. Frabizzio is of counsel at Robson & Robson where he focuses his practice on tax planning and controversy. Frabizzio holds an LL.M. in taxation and helps clients minimize their federal and state tax obligations associated with business transactions. He also assists clients with complex trusts and estates issues and succession planning. Contact him at 610-825-3009 or jfrabizzio@robsonlaw.com.