Planning with Retirement Benefits

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More and more people are holding the bulk of their wealth in qualified plans and individual retirement accounts (IRAs). Although most plan participants know that these vehicles provide income tax-free growth for assets held in them, few understand the rules regarding plan distributions. With proper planning, participants can make the most of this income tax benefit and even pass some of that benefit on to their beneficiaries.

Income Taxation of Qualified Plans and IRAs

Although assets held in qualified plans and IRAs (Plans) generate no current income tax liability, the distribution of those assets to a participant (P) or P's beneficiaries in a future tax year does, generally at ordinary income tax rates on every dollar. The IRS also imposes "penalty" taxes on withdrawals made either too soon or not soon enough. If P withdraws assets from a plan before reaching 59 1/2, he or she will have to pay a 10% penalty tax in addition to the payment of ordinary income tax on the withdrawal (unless one of several limited exceptions applies). More onerous is the additional penalty tax imposed if P does not make a required minimum distribution after reaching his or her "required beginning date" (RBD), which generally is April 1 of the year after the year in which P reaches age 70 1/2. On that date, P must receive certain minimum withdrawals. If P does not do so, a 50% penalty tax is imposed on the amount that should have been withdrawn but wasn't (again, in addition to the ordinary income tax on the distribution).

In other words, there is potential tension between P, who may not want to receive any Plan withdrawals even after the RBD, and the IRS, which monitors the statutorily mandated withdrawals to be made and taxes to be paid. The good news is that, with proper planning, P can decrease the size of the required minimum distribution and increase the Plan's income tax benefit.  Note that these required minimum distributions provide a floor, not a ceiling; P is always free to withdraw more than the minimum amount if needed for living and health expenses in retirement.

Distribution of Plan Assets to the Participant

As noted above, P usually should not withdraw Plan assets before reaching 59 1/2 to avoid the 10% penalty tax, and must take required minimum distributions after reaching the RBD to avoid the 50% penalty tax.  In most cases the required minimum distribution is determined using the uniform lifetime table contained in the regulations. The uniform lifetime table is based on the joint life expectancy of P and a beneficiary 10 years younger than P. However, if P has named P's spouse as the sole beneficiary and the spouse is more than 10 years younger than P, the actual joint life expectancy of P and P's spouse, calculated each year, is used. Although it does not matter whether P has a designated beneficiary, (DB) for purposes of determining the required minimum distribution while P is alive, as discussed below, it does matter after P's death.

Generally, P is provided with distribution forms on the date of his or her Normal Retirement Date, as defined in the controlling plan document.  Although optional forms of distribution might be offered, if the plan is a defined benefit plan (such as a traditional pension plan), then the normal form of benefit is usually a life annuity for a single P and a joint and survivor annuity if P is married; and if the plan is a defined contribution plan (such as a 401(k) plan or a profit sharing plan), then the normal form of benefit is generally a single distribution of the entire account balance, which can generally be rolled into an IRA within 60 days of the distribution.  These elections are irrevocable, and such options should be discussed as part of the planning before any decisions are made by the P. 

Distribution of Plan Assets After the Participant's Death

On P's death, Plan assets are distributed to P's beneficiaries in accordance with rules that change, depending upon the beneficiaries' identities and the date of P's death.

First if the sole beneficiary is P's spouse, then the spouse can always roll over the Plan assets into a new IRA, giving the spouse the ability to use his or her own life expectancy and name a new DB, achieving even greater deferral. This ability to roll over Plan assets is limited to P's spouse, and only if the beneficiary is the spouse individually, not a trust for his or her benefit unless the spouse has the right to withdraw the Plan assets from the trust. Although the spouse has other options, rolling over Plan assets will almost always be the best choice.
Second, if sole the beneficiary is not P's spouse and if P dies before the RBD, there are two options. If the beneficiary is a DB, then the beneficiary can withdraw Plan assets over his or her life expectancy. If the beneficiary is not a DB, then the beneficiary must withdraw all Plan assets (and pay income taxes on the withdrawal) within 5 years of P's death. Note that the 5-year rule also applies if the DB fails to make his or her first required distribution by December 31 of the year after the year in which P dies.

Third, if P dies after the RBD and has a DB, the DB must withdraw Plan assets over the longer of the DB's life expectancy or P's remaining life expectancy. If P did not have a DB, the Plan assets must be withdrawn over P's remaining life expectancy.

A trust can also be named as a DB, but only if drafted and communicated in accordance with strict provisions in the Treasury Regulations.  The naming of a DB is a complicated procedure, and any good estate planner should become familiar with them, as different clients will normally require different advice.

Estate Tax Considerations

In addition to the income tax issues described above, the value of the assets in the Plan on P's death will be included in P's estate when determining estate tax liability. Unless P's beneficiary is P's spouse or charity (and the marital or charitable deduction applies), the Plan assets could be subject to estate tax of 45%. If assets are withdrawn from the Plan to pay this tax, that withdrawal will generate an income tax liability on top of the estate tax liability.

Planning Considerations

In light of the factors above, a Plan participant should always consider the following:

The Beneficiary Designation Form Governs:

Participants routinely (and wrongly) assume that their wills govern the distribution of Plan assets. These assets are distributable to the beneficiary named on the form, or according to the default method in the Plan, regardless of the provisions of the participant's will.

Always Name a DB, if Possible:

As noted above, without a DB, the ability to defer withdrawals from a Plan by beneficiaries may be limited.

Review the Plan Periodically, and Always Just Before the RBD:

The beneficiary designation should be reviewed at regular intervals, and after a major life event such as divorce or a death in the family.

Advanced Planning:

If a participant has a large Plan balance or a complicated estate plan that involves, for example, distributing Plan assets to trusts for minor children or partially to charity and partially to children, the participant should consider working with an expert in this area to obtain the best tax planning advice.


Disclaimer of Liability: This site is provided as a public service by the ABA Section of Real Property, Trust and Estate Law. While the information on this site is about legal issues, it is not legal advice or legal representation. Because of the rapidly changing nature of the law and our reliance upon outside sources, we make no warranty or guarantee of the accuracy or reliability of information contained herein or at other sites to which we link. We assume no responsibility for any information, advice or services provided by any site to which we link.