Estate Planning FAQs

Planning with Retirement Benefits

Updated As Of June 2018

Planning with Retirement Benefits

More and more people are holding the bulk of their wealth in qualified plans and individual retirement accounts (“IRAs”), including Roth IRAs.  Although most plan participants know that these vehicles provide tax-deferred or income tax-free growth for assets held in them, few participants understand the rules for 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

When are participants taxed on retirement plan contributions?

Assets held in qualified plans and IRAs normally generate no current income tax liability.  The distribution of those assets to a participant or a participant’s beneficiaries in a future tax year, however, generally triggers income tax liability at ordinary income tax rates.  However, a significant exception applies for Roth contributions.

What is the exception for Roth contributions?

Roth contributions to a Roth IRA or to a designated Roth account in a qualified plan are made on an after-tax basis.  Roth contributions included in a distribution from a Roth IRA or a qualified plan are not taxable, but the earnings on those Roth contributions may or may not be taxable.  If the distribution is a “qualified distribution,” then those earnings are not taxable.  Earnings in a distribution that is not a “qualified distribution” are taxable.  A “qualified distribution” from a Roth IRA or a qualified plan generally is a payment made after the participant reaches age 59-1/2 (or death or disability) and after the 5-taxable-year period commencing with the first taxable year for which the participant made Roth contributions to the Roth IRA or the plan, as the case may be.

Is there a penalty for receiving a distribution from the plan before retirement?

The Internal Revenue Code (“Code”) imposes a tax penalty on withdrawals made either too soon or not soon enough.  For example, if a participant withdraws assets from a plan before reaching age 59-1/2, the participant will normally be responsible for paying ordinary income tax on the taxable portion of the distribution, plus a 10% tax penalty on the taxable portion of early distributions (unless a limited exception applies).  Roth contributions are not subject to this tax penalty, but earnings on Roth contributions are if they are not part of a qualified distribution.  Information on the exceptions to the 10% penalty tax for qualified plan distributions may be found in IRS Publication 575 (Pension and Annuity Income), and information on the exceptions to the 10% penalty tax for IRA distributions may be found in IRS Publication 590-B (Distributions from Individual Retirement Accounts (IRAs)).

Are there any options for accessing a qualified plan account balance before retirement?

The tax rules allow qualified plans to adopt certain features to allow participants to use their qualified plan account balances before reaching retirement.  For example, a 401(k) plan may allow participants to request hardship withdrawals in the event of an immediate and heavy financial need.  The tax rules also allow plans to make loans available so that participants can borrow against their account balances (up to a certain statutory limit) and make repayments directly to their plan accounts with interest added.  Hardship withdrawals are taxed as early distributions, but properly made plan loans generally have no income tax consequence unless the loans are not repaid to the plan as agreed.  Two other distribution options that a plan may offer to participants are in-service distributions for participants who have reached age 59-1/2 and disability distributions.  Participants should consult their plan administrators, official plan documents, and summary plan descriptions for additional details about whether their plans offer these and other distribution features.

What happens to the qualified plan account balance in a defined contribution plan if a participant moves to a different employer?

Plan terms generally govern when distributions may occur for a terminated participant, although the tax rules require qualified plans to permit terminated participants to roll over their vested account balances to an eligible retirement plan, such as another employer’s plan or an IRA.  Any rollover of Roth contributions from an employer’s plan must be to a Roth IRA or to another employer’s plan that accepts Roth contribution rollovers.  Direct rollovers from one plan to another plan generally are tax-free rollovers.  If a participant elects to receive the rollover check instead of conducting a “direct” rollover to an eligible retirement plan, mandatory 20% income tax withholding normally applies to the taxable portion.  For small account balances totaling up to $1,000, many plans require participants to accept a lump sum distribution of the entire account balance.  For balances between $1,000 and $5,000, most plans include the Code’s automatic IRA rollover rule that requires the plan to roll over the participant’s account balance to an IRA established by the plan on behalf of the participant.  Plans generally permit participants to retain in the plan any account balance that exceeds $5,000.  These distribution rules are plan-specific, so it is important to consult the official plan documents or the summary plan description for additional details about plan offerings.

What happens if a participant does not start receiving plan benefits at age 70-1/2?

More onerous than the early distribution tax penalty is an additional penalty tax imposed if a participant does not begin receiving certain minimum withdrawals, called “required minimum distributions” (“RMDs”), commencing by the participant’s “required beginning date” (“RBD”).  The minimum distribution rules apply to qualified retirement plans, IRAs − including traditional IRAs, Roth IRAs (but only after a participant’s death), Simplified Employee Pension (“SEP”) IRAs and Savings Investment Match Plan for Employees (“SIMPLE”) IRAs – and 403(b) plans.  The tax rules require that participants begin receiving RMDs as of the RBD.  The RBD generally is April 1 of the year after the year that the participant reaches age 70-1/2.  (Separate RBD rules may apply to participants who remain employed after reaching age 70-1/2 or who are owner-employees.)  However, RMDs are not required from a Roth IRA during the Roth IRA owner’s lifetime.  If a participant elects to delay RMDs until April 1, instead of electing to receive the first RMD in the year that the participant reached age 70-1/2, the participant will be required to accept two RMD payments–one for the year that the participant reached age 70-1/2 and another for the year that includes the April 1 date.  In other words, if the participant postpones RMDs until April 1 (generally, the latest date that the participant may postpone RMDs) the participant will be required to accept two RMDs for the first year of retirement.  If a participant does not timely withdraw RMDs in a given year, a 50% tax penalty is imposed on the amount that should have been distributed to the participant on top of the federal income (and, if applicable, state) taxes that ordinarily apply to plan distributions.  For good cause, however, the IRS may waive the 50% penalty if the participant follows the guidelines explained in IRS Instructions to Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts) and files Form 5329.

What happens if a participant receives more than one RMD (i.e., duplicate checks) for the same year?

If a participant receives more than one RMD payment, the participant should contact the plan administrator as soon as possible.  Plan rules may allow participants to elect partial withdrawals so that, if desired, the plan may allow the participant to keep the second check.  For participants who prefer to redeposit the funds back into the plan, options may be limited if the participant cashes the check.  Under all circumstances, however, the participant should contact the plan administrator for additional instructions.

Summary

As you can see, there is a potential tension between a participant who may not want to receive any plan withdrawals even after the RBD and the IRS which monitors the statutorily-mandated withdrawals (i.e., the RMDs).  The good news is that, with proper planning, a participant can decrease the size of the RMD and increase the plan’s income tax benefit.  Note that RMDs provide a floor, not a ceiling.  Participants generally are free to withdraw more than the minimum amount if needed for living and health expenses after retirement.  As noted, RMDs are not required of a Roth IRA during the Roth IRA owner’s lifetime.

Distribution of Plan Assets to the Participant

How are plan benefits distributed after retirement?

Generally, participants are provided with distribution forms on the participant’s “normal retirement date,” as defined in the controlling plan document.  (Many defined contribution plans, such as 401(k) plans, allow distributions after termination of employment before normal retirement age.)  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 participant and a joint and survivor annuity if the participant is married.  Other options may be offered and should be considered carefully.  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 generally is a single distribution of the entire account balance which can be transferred (or “rolled”) into an IRA within 60 days after the distribution.  These elections are irrevocable, and these options should be discussed as part of the retirement planning sessions before any decision is made by the participant.

How are RMDs determined?

In most cases, the RMD is determined using the uniform lifetime table contained in Treasury Regulations.  (RMD regulations appear in the Code of Federal Regulations (“C.F.R.”), beginning at 26 C.F.R. section 1.401(a)(9).)  The uniform lifetime table is based on the joint life expectancy of the participant and a beneficiary who is 10 years younger than the participant.  However, if the participant’s spouse is named as the sole beneficiary and the spouse is more than 10 years younger than the participant, the actual joint life expectancy of the participant and the participant’s spouse, calculated each year, is used.

What happens if a participant has more than one retirement plan?

If the participant has more than one qualified retirement plan, the RMD must be calculated separately for each plan, and each plan must distribute the RMD relevant to that plan.  In contrast, where a participant has more than one (non-Roth) IRA, though the RMD must be separately calculated for each plan, the participant may take the aggregate of the RMDs from one IRA or a combination of the IRAs.  Similarly, a participant with multiple 403(b) plans may withdraw the aggregate RMD of all 403(b) plans from one 403(b) plan or a combination of the 403(b) plans.

Summary

As previously mentioned, participants generally should not withdraw plan contributions before reaching age 59-1/2 to avoid the 10% tax penalty.  Participants, however, should withdraw required minimum distributions after reaching the RBD to avoid the 50% tax penalty.

Distribution of Plan Assets After the Participant’s Death

How are plan benefits distributed after a participant’s death?

Upon a participant’s death, plan assets are distributed to the participant’s beneficiaries generally in accordance with the participant’s written beneficiary designation submitted to the plan administrator or IRA custodian.  For RMD purposes, the participant’s designated beneficiary is especially important as the RMD rules change depending on the beneficiary’s identity and the participant’s date of death.  A deceased Roth IRA owner is treated for these purposes as dying before the participant’s RBD.

After a participant dies, the minimum distribution rules apply to the beneficiary of the retirement plan.  The beneficiary may choose to withdraw his or her share of the account in full, but assuming the beneficiary does not, then distributions will be based on the life expectancy of the beneficiary, the remaining life expectancy of the participant, or the “5-year rule.” Which distribution scheme applies depends on whether the participant died before, on, or after his or her RBD.  If the participant died on or after his or her RBD, then the beneficiary needs to determine if the participant took all, none, or a portion of his or her RMD for the year of death.  If the participant did not take it in full, the remaining amount of the RMD must be taken by the beneficiary by the end of the year of the participant’s death.  If there are multiple beneficiaries, it is not necessary to apportion the year-of-death RMD among the beneficiaries; any one beneficiary may satisfy the participant’s year-of-death RMD, although this would require coordination among the beneficiaries.

Who is considered a “designated beneficiary” under the RMD rules?

A designated beneficiary is the individual designated as the beneficiary under the participant’s plan.  Plans generally permit participants to file formal designations specifying particular persons as beneficiaries, although a participant need not file a formal designation for RMD purposes as long as the official plan document identifies a beneficiary in the absence of the participant’s affirmative designation (e.g., the participant’s spouse).  If more than one beneficiary is named, then all of them must be individuals, and it must be possible to identify the oldest member of the class.

Can a participant name a trust or estate as designated beneficiary?

A participant’s estate generally will not be considered as a designated beneficiary under the RMD rules.  (Naming one’s estate as beneficiary usually results in acceleration of RMDs.)  A trust, however, can be named as a designated beneficiary for RMD purposes, but only if drafted and communicated in accordance with the strict provisions in the Treasury Regulations.  If a trust complies with the RMD rules for trusts and thus qualifies for “see through treatment,” then RMDs after the participant’s death are calculated based on the life expectancy of the oldest of the trust’s beneficiaries (or, if greater, the life expectancy of the deceased participant if the participant reached his or her RBD before death) so that the benefit of the trust’s qualification is that continued tax deferral is permitted.  In addition to specific language being included in a trust intended to qualify for “see through treatment.” a copy of trust documentation must be provided to the plan administrator or IRA custodian by October 31 of the year following the year of the participant’s death.

Are there any special distribution options for designated beneficiaries who are spouses?

If the participant’s spouse is the sole designated beneficiary, the surviving spouse can roll over the plan benefit to a qualified plan, to an “inherited IRA,” or to a new IRA in the spouse’s name, giving the spouse the ability to use the spouse’s own life expectancy and name a new designated beneficiary, potentially achieving even greater deferral.  If the participant died before the participant’s RBD (and the participant’s spouse is the sole designated beneficiary), the spouse also may be able to delay the start of RMDs until the later of (i) the end of the year after the year that the participant died or (ii) the end of the year that the participant would have reached age 70-1/2.  However, if the spouse has not reached age 70-1/2, the spouse may lose access to the funds in the plan.

What are the distribution options for designated beneficiaries who are not spouses?

If the participant’s designated beneficiary is not the participant’s spouse, the distribution options will depend on whether the participant dies before or after the RBD.  Assuming the beneficiary is a designated beneficiary, the beneficiary can withdraw the plan benefit over the beneficiary’s life expectancy if the participant dies before the RBD.  If the participant dies after the RBD, the designated beneficiary must withdraw the plan benefit over the longer of (i) the beneficiary’s life expectancy or (ii) the deceased participant’s remaining life expectancy.  As an alternative, tax rules allow non-spouse beneficiaries to make a direct rollover of a deceased participant’s plan benefit to an “inherited IRA.”  Note, however, that if a designated beneficiary fails to take the RMD by December 31 of the year after the year the participant dies, the tax rules require the designated beneficiary to receive a total distribution of the participant’s entire plan benefit within 5 years after the participant’s death.  If a beneficiary has missed an RMD, whether in whole or in part, then the beneficiary may request a waiver of the 50% penalty by filing the Form 5329 (as described earlier) for each year in which he or she missed an RMD, along with a statement demonstrating that the shortfall was due to reasonable error and that reasonable steps are being taken to remedy the shortfall.

What happens if the participant does not have a designated beneficiary?

If the participant dies before the RBD and the participant does not have a beneficiary or the beneficiary is not considered a “designated beneficiary” for RMD purposes (e.g., an estate), the tax rules require a distribution of the participant’s entire plan benefit by the end of the fifth calendar year following the calendar year of the participant’s death.  If the participant dies after the RBD, the beneficiary must withdraw the plan benefit over the participant’s remaining life expectancy.  IRS and Department of Labor rules generally require plans to make diligent efforts to locate missing participants and plan beneficiaries.

Summary

The naming of a designated beneficiary can be a complicated procedure.  Different plans will require different processes, and different estate planning clients normally require different advice.  You should consult a competent estate planning attorney for additional details.

Estate Tax Considerations

In addition to the income tax concerns described above, a participant’s assets in a plan generally are included in the participant’s estate when the participant dies and will be used to determine estate tax liability.  The plan assets could be subject to federal and state estate taxes, unless the participant’s beneficiary is the participant’s spouse or a charity (so that the marital or charitable deduction applies).  If assets are withdrawn from the plan to pay this tax, the plan withdrawal generally will generate income tax liability on top of the estate tax liability.  Retirement plan beneficiaries and their advisors should be mindful of Code section 691(c), under which a beneficiary can claim a federal income tax deduction for any additional estate tax taxes caused by the inclusion of the plan(s) in a participant’s estate.

Planning Considerations

You should consult a competent tax accountant or tax attorney for tax and estate planning advice.  Considering the information above, following are some items that may be helpful to review with your tax and estate planning advisor(s):

·         Beneficiary Designation Form Governs

Participants routinely (and wrongly) assume that their wills govern the distribution of plan assets.  Plan assets are distributed to the beneficiary named on the applicable plan form, or according to the default method specified in the plan document, regardless of the provisions in a participant’s will.  Spousal consent is usually required to designate a non-spouse beneficiary in a qualified plan.  Be sure to review your beneficiary designations, at least annually, or when there is a major life event (such as a divorce, remarriage or the death of a spouse).  Note, however, that a qualified domestic relations order (often referred to as a “QDRO”) may prohibit changing the beneficiary for your plan account.  Consult your advisor for additional details concerning this.

·         Always Name a Designated Beneficiary

As noted above, without a designated beneficiary, the ability to defer taxable withdrawals from a plan by your beneficiaries may be limited.

·         Review the Plan Periodically, and Always Just Before the Required Beginning Date

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

·         Advanced Planning

If you have a large plan account 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, or concerns about creditor’s access to retirement funds, you should consider working with an expert in this area to obtain the best tax planning and legal advice.

·         Special Rules

This article provides only a general overview of retirement plan distribution issues under federal law.  State, local or foreign tax treatment may vary. The Code is riddled with special rules and exceptions.  In some cases, IRA rules differ from qualified plan rules, and there are special rules for employee stock ownership plans and plans of governmental agencies and tax-exempt organizations as well.