Ten Serious Mistakes to Avoid in Estate Planning

5. Failure to Coordinate Retirement Account Designation with Your Estate Plan.

Planning for distributions from retirement accounts is so important in most estates that it deserves special mention. Except for Roth IRAs, retirement account benefits (including 401(k) accounts) consist of money on which you have not paid income taxes. Generally, you have to take what are called “required minimum distributions” (RMDs) each year, beginning with the year after you turn 70 ½ (the year 2009 was an exception). If you fail to name a beneficiary, then the retirement account passes to your estate. This is a bad result, because if you have a designated beneficiary (assuming that the financial institution will permit it), your beneficiary spread out RMDs over the beneficiary’s lifetime. This permits your beneficiary to defer income taxation until a distribution is actually taken.

That doesn’t mean that your beneficiary is restricted to taking only the RMD – if your beneficiary wants, more that the RMD can be taken out in any year, but of course by doing so, your beneficiary will incur income taxation on that additional amount distributed.

If there is no designated beneficiary of a retirement account (including a contingent beneficiary if the first named beneficiary predeceases) and the estate is treated as the beneficiary, then the retirement account must be distributed over a period of time not to exceed five years. And on top of having much more income to be taxed upon, an estate is taxed at the highest marginal income tax rate once an estate has income of approximately $11,000. So there is the potential for extremely adverse tax consequences.

If, for example, testamentary trusts are going to be established for the benefit of children, the trust itself can be named as the designated beneficiary (and this is preferable to simply naming the children as the beneficiaries if trusts are otherwise advisable – see #5. Those trusts (and indeed the will itself) will have to be carefully drafted to conform to many technical rules to take advantage of tax deferral while ensuring that the beneficiary cannot obtain outright access to the retirement benefits until you intend for him or her to obtain access to trust property.

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