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Retirement accounts, including pensions, 401(k)s, and IRAs, often represent a significant portion of a person’s wealth. When it comes to estate planning, it’s crucial to understand how these accounts fit into the bigger picture of your estate plan so you can ensure your loved ones are taken care of exactly as you intend.
From Pensions to 401(k)s: A Shift in Retirement Planning
Pensions used to be the gold standard for retirement. In the late 1800s, American Express introduced the first private pension plan, and by 1980, about 40% of Americans had a traditional employer-funded pension. These Defined Benefit (DB) plans guaranteed a monthly payment for life after retirement, calculated based on your salary and length of service.
Fast forward to today, and things look a bit different. Employers have largely moved away from DB plans in favor of Defined Contribution (DC) plans like 401(k)s. These plans put the responsibility on you, the employee, to save for your own retirement. While employers often offer matching contributions, the funds in a DC plan are controlled and managed by you, not the employer. By 2020, 85.3 million Americans had a DC plan, while only about 12 million still had a traditional pension.
From an Estate Planning standpoint Pensions are not an asset of your estate and therefor do not count when determining whether your estate would have to pay any estate tax – whereas Defined Contribution plans like 401k and IRA’s are considered as an asset of your estate.
Avoiding Probate with Your Retirement Accounts
Retirement accounts must be owned by an individual, so they cannot be transferred into a revocable living trust during the participant’s lifetime like most other financial accounts or property. Further, they cannot be jointly owned. Thus, the only way to control how these accounts transfer at the time of the participant's death is through the use of properly designated beneficiaries.
Understanding Beneficiary Designations for DB Plans and DC Plans
Pensions: With a DB pension, there are specific rules about who can be named as a beneficiary. In most cases, your spouse is automatically entitled to receive the pension benefits when you pass away. If you want to name someone else—whether that’s a child, a sibling, or a trust—your spouse usually needs to sign a waiver.
401(k)s and other DC Plans: 401(k)s and other DC Plans will generally automatically name a person’s spouse to receive the benefit if the account holder dies. If you want to name someone other than your spouse, then generally the spouse will need to consent by signing a waiver. Your Employer owns the DC Plan and sets the term – so its important that you know what the rules are for beneficiaries for your specific DC Plan.
Individual Retirement Accounts: IRA’s are not covered by the same ERISA laws as DC Plans and therefore an IRA holder can name any person they want to be a beneficiary without needing their current spouse’s consent.
Divorce: No matter what type of Retirement Plan you have - if you’ve gone through a divorce or remarriage, it’s critical to review and update your beneficiary designations. Failing to do so could result in an ex-spouse inheriting your retirement assets, which may not align with your current wishes.
The SECURE Act: How It Impacts Your Heirs
One of the most important changes to retirement planning in recent years came with the passage of the SECURE Act in 2019. This law, which took effect in 2020, introduced new rules for how retirement accounts are inherited—and these rules have major implications for your estate plan. Here is a brief summary as of the time this blog was written:
1. Increased Age for Required Minimum Distributions (RMDs)
Before the SECURE Act, retirees had to start taking required minimum distributions (RMDs) from their retirement accounts at age 70.5. The SECURE Act raised that age to 72, and in 2023, it increased to 73. This means retirees can keep their money growing tax-deferred for a longer period before they’re required to start withdrawing.
2. The 10-Year Withdrawal Rule for Inherited Accounts
Perhaps the biggest change under the SECURE Act is the new rule for non-spouse beneficiaries who inherit a retirement account. Before the law passed, beneficiaries could "stretch" the withdrawals over their lifetime, which helped to minimize taxes and keep the account growing. However, the SECURE Act changed that for most non-spouse beneficiaries. Now, they must fully withdraw the balance of the inherited account within 10 years of the original account holder’s death. This can lead to a significant tax burden if not planned for properly, especially if the account balance is large.
There are a few exceptions to this rule. Minor children of the account holder can delay the 10-year rule until they turn 21, and certain beneficiaries—such as surviving spouses, disabled individuals, and those within 10 years of the deceased’s age—can still use the old "stretch" rules.
3. Spousal Benefits Under the SECURE Act
Spouses still receive favorable treatment under the SECURE Act. When a spouse inherits a retirement account, they can roll it over into their own IRA and continue to treat it as their own. This allows them to name their own beneficiaries and defer RMDs until they reach the required age, which offers significant tax advantages.
Retirement Accounts and Trusts
It is possible to name a trust as the beneficiary of your retirement accounts; however, you should consult with an experienced estate planning attorney that knowledgeable in this area. There can be negative income tax implications if a trust that is not set up properly is the beneficiary of a retirement account.
Charities as Beneficiaries
There are benefits to naming charities as beneficiaries of retirement accounts. One benefit is that charities do not pay any income tax on retirement account assets they receive. A second benefit is that any asset that is given to charity at death does not count as an asset for calculated estate tax.
Maximizing the Value of Your Retirement Accounts for Your Loved Ones
Your retirement accounts might just be the largest financial asset you leave behind for your loved ones. Ensuring that they’re passed on correctly—and with the least amount of tax burden—is essential.
This article is a service of Attorney Chad A. Ritchie and the Ritchie Law Office, Ltd.
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