How Failing to Coordinate Retirement and Estate Planning Can Cut Your Retirement Account in Half

This blog post will focus on coordinating your retirement planning with your estate planning. Retirement planning amounts to formulating a game plan for when you will no longer be bringing home a paycheck, and deciding how you want to live out your dreams for yourself and your family after retirement. However, failing to make sure your estate planning is coordinated with your retirement planning can have serious adverse effects on your estate and its beneficiaries.

Key Takeaways

• It's extremely important to coordinate retirement planning and estate planning so your estate doesn't suffer adverse consequences

• Retirement accounts carry with them strict rules regarding withdrawals and distributions, so it's important to plan ahead with estate planning

• Failing to address retirement planning in your estate planning can lead to a 50% excise tax, leaving your beneficiaries with markedly less asset to inherit 

SOCIAL SECURITY AND RETIREMENT PLANNING

As a preliminary matter, you might be wondering whether Social Security will take care of you. While it’s a good starting point for retirement planning, studies in the past have shown Social Security is lacking. Take EBRI Retirement Income Research, which found that Social Security, even when combined with other retirement programs, will provide only about 42% of what the retiree needs.  The remaining 58% will have to come from investments, savings, pensions, annuities, and earnings from work. (EBRI Retirement Income Research: 2003 Findings. “Income of the Elderly Population: 2001,” June 2003, Notes.)

We are also less and less confident in Social Security being around for us when we need it. EBRI Retirement Income Research also shows that "Just 37 percent of workers say they are very or somewhat confident that the Social Security system will continue to provide benefits of at least equal value to the benefits received by retirees today, including just 6 percent who are very confident." (The 2017 Retirement Confidence Survey: Many Workers Lack Retirement Confidence and Feel Stressed About Retirement Preparations, Page 22.)

Retirement planning is important because most of us will have to provide for ourselves after we retire and as you can see, Social Security can help, but it is not the answer. In fact, it was never intended to be a sole source of retirement income. Especially in a period of ever extending retirement timeframes. Retirement used to be a brief period, but now as healthcare has improved, Americans are living longer and therefore have to account for a longer retirement. Longer retirements, meaning more spending and spending takes money.

Another thing to keep in mind before we get started is that it’s never too early to start planning for retirement. Starting as early as possible gives you a couple of big benefits. These include taking advantage of time and compound interest until and perhaps through retirement, meaning the more time you have to save and the more interest can compound, the more money you can make. The other benefit of starting to save for retirement early is it builds good habits that most people don’t get around to creating, which is to say that you will become used to saving and it will not seem like such a burden if ramped up correctly over time and in appropriate circumstances.

THE RELATIONSHIP BETWEEN RETIREMENT PLANNING AND ESTATE PLANNING

Retirement planning and estate planning can seem to be at odds with one another. Specifically, retirement planning is the vehicle we use to build up a fund during our working years to create a pool of money to support a desired lifestyle after retirement. Estate planning, on the other hand, is the vehicle we use to ensure the wealth we create during our lifetime is preserved so we can pass it along to others (actually this is only part of estate planning as incapacity planning is often the most important aspect of estate planning for most people).

Despite this dichotomy, estate planning and retirement planning intersect where retirement assets are intended to be passed on to beneficiaries. For a lot of people, retirement accounts will be drawn down entirely through retirement. But for those lucky enough to have retirement assets to pass along to others, proper coordination between retirement planning and estate planning can be the difference between effectively transferring wealth and causing a huge tax burden for beneficiaries (more on this later).

At this point of inflection, we find that the rules regarding retirement accounts have a great effect on our estate planning. For instance, despite the fact that naming a beneficiary on your retirement plan determines who inherits the funds on your death, how these accounts are inherited by those beneficiaries can affect the associated tax burden. This is because tax-deferred retirement accounts are considered income in respect of a decedent assets (IRD), so your heirs will be responsible for paying the income taxes on the balance of the funds that they inherit. Retirement accounts are also subject to the federal estate tax.

For most people, retirement funds amount to their largest asset, often rivaling or exceeding the value of their home. This especially so in cases where saving took place over 30 to 40 years of working life. More often than not, people save over their lifetimes by contributing to a 401(k) or IRA. In this post, we'll focus on distributions from traditional IRAs and 401(k)s, and how you can limit tax burden of beneficiaries. If you have questions regarding estate planning and Roth IRAs or Roth 401(k)s, give us a call!

DISTRIBUTIONS FROM TRADITIONAL IRAs AND 401(K)s

Distributions rules from IRAs and 401(k)s depend on whether withdrawals are made from the account prior to age 59 1/2 or between the ages of 59 1/2 and 70 1/2. Early withdrawals from 401(k)s are those that are made prior to age 59 1/2. If withdrawals are made early, a 10% penalty is tacked onto the withdrawal amount, and you will also have to pay ordinary income taxes on the withdrawal amount.

As you've likely heard, there are some exceptions to this rule. They include the death of the plan participant, permanent disability, separation from the service of an employer after reaching age 55, or a rollover of 401(k) to another Qualified Plan. Some plans also allow for distributions prior to age 59 1/2 in other circumstances including a series of substantially equal periodic payments, medical expenses exceeding 7 1/2% of gross income, certain health insurance premiums, post-secondary education costs, or qualified domestic relations orders.

As for distributions from a 401(k) between the ages of 59 1/2 and 70 1/2, they’re generally speaking for payout choices: an annuity based on life expectancy, an annuity over fixed period of time, a lump sum distribution in cash, and a lump sum rollover to another Qualified Plan. For those that are married, options are generally limited to a joint and survivor annuity for you and your spouse unless there is spousal consent in writing to another form of payment.

There are similar rules for early withdrawals from traditional IRAs including a 10% penalty prior to age 59 1/2 in addition to income taxes less certain exceptions that apply. Exceptions include death before age 59 1/2, distributions that are used for first time homebuyers, for expenses of up to $10,000, and all the other exceptions that apply to 401(k)s listed above. After age 59 1/2, there are no restrictions on withdrawals for traditional IRAs.

REQUIRED MINIMUM DISTRIBUTIONS AT AGE 70 1/2

Retirement plans were designed for...wait for it...retirement (surprise!) Because they are designed to be used by an individual during that period, you must begin to withdraw funds from your traditional IRA the year you reach 70 1/2. Technically you can postpone taking the withdrawal until April 1 of the following year, but 70 1/2 is the age you need to start taking withdrawals. This day is known as the required beginning date. Each year after that date, you must take a required minimum distribution or RMD from your IRA.  We calculate your RMD using a life expectancy table that the IRS publishes specifically for this purpose (there are actually two tables, the Uniform Lifetime Table and the Joint Life and Last Survivor Expectancy Table. 

In order to determine your RMD, you divide the fair market value of your IRA as of December 31 of the previous year by the appropriate divisor of your age as shown in the appropriate table. For example, if you’re 74 years old in 2018 and your wife is 65 or you named anyone other than your wife as a beneficiary, the divisor on the Uniform Lifetime Table is 23.8. If your IRA was worth $250,000 on December 31, 2017, divide 250,000 by 23.8, and the resulting $10,504.20 is your RMD.

If your spouse were more than 10 years younger than you, say 60 and 74, respectively, in 2018, and your spouse is the sole beneficiary of your IRA, you would use the Joint Life and Last Survivor Expectancy Table. According to that table, the joint life expectancy of a 74-year-old and a 60-year-old is 26.6 years, so your RMD for 2018 on a $250,000 account is $9,398.50, which is determined by dividing 250,000 by 26.6.

What if I don’t take required minimum distributions?

The penalty for failing to take an RMD is one of the most severe penalty posed by the IRS. Specifically, you will pay a 50% penalty on the amount of your RMD that you failed to take out each year. For example, if your RMD for this year is $10,000 and you took no distribution at all, you'll pay out $5,000 a penalty, which is 50% of $10,000 or the amount that you failed to take out. As you can see, failing to take your RMDs can cut your retirement account in half!

Note that the penalty is imposed on the amount you fail to take out. So, if your RMD is $10,000 and you took a distribution of $3,000, you'll pay out a penalty of $3,500, which is 50% of $7,000 or the amount that you failed to take out.

BENEFICIARIES OF QUALIFIED RETIREMENT PLANS AND IRAS

With all these rules regarding distributions of funds, you might be wondering what to do. Spend it all?! While that's certainly an option (and sounds pretty awesome), retirement account owners should that plan on passing the proceeds of 401(k)s and IRAs to beneficiaries should coordinate their estate plans with their retirement planning.

Coordination in this case means planning in a manner that allows the beneficiaries to "stretch out" the withdrawals over the longest period possible, thereby deferring income taxes and maximizing compound interest. Remember, the longer the plan assets remain in the tax-deferred account, the greater the tax free accumulation.  In California, your spouse must be the beneficiary of your retirement accounts unless your spouse consents otherwise. Often times, married couples leave these plans to each other, and when the survivor of them passes away, a child or children is listed as the beneficiary or beneficiaries.

If you name your spouse as the sole beneficiary of your 401(k) or IRA, and you die before your required beginning date, your spouse must receive RMDs based on your spouse's life expectancy or your life expectancy, whichever is longer (even though you’re no longer alive, you still have an actuarial life expectancy). Alternatively, your spouse as beneficiary can purchase an annuity contract meeting IRS requirements.

Generally speaking, the surviving spouse will receive smaller distributions from the account by choosing to be treated as an owner. The main benefit to electing treatment as a beneficiary is that the spouse can receive distributions prior to age 59 1/2 without incurring a penalty for early distributions.

NON-SPOUSE INDIVIDUALS AS BENEFICIARIES

So what happens if you name someone other than your spouse as beneficiary of your IRA or 401(k) and how does that person receive the money? First, your beneficiary always has the option of taking a lump sum distribution of the whole account. Not always the best option. If your beneficiary is looking to defer the distributions as long as possible and thereby defer income taxes and maximize compound interest, here are the rules:

If you die before your required beginning date, your beneficiary must either take distributions from the account based on his or her life expectancy, which begins December 31 of the year after your death; or your beneficiary can withdraw the account balance within five years following the year of your death.

If you die after your required beginning date, your beneficiary can take distributions over your remaining life expectancy or over the beneficiary's life expectancy, whichever is longer; or the beneficiary can elect to withdraw the entire account balance within five years following the year of your death. For either of the life expectancy options, distributions must begin by December 31 of the year following your death.

For discussion regarding naming multiple beneficiaries on a single retirement account, or naming a revocable living trust as the beneficiary, please contact us.

FAILING TO COORDINATE ESTATE PLANNING AND RETIREMENT PLANNING

If you’re like most people, you will have some sort of retirement planning over a lifetime of thirty to forty years of work, even if that planning and savings is small. Most people also fail to conduct the estate planning; at least statistics support this. In the event this happens, there can be severe consequences for your beneficiaries.

First, if your spouse is named as a beneficiary and you live in California, the assets in the account will pass to your spouse as community property. While is this is all good and well, this alone does nothing for the accounting of the assets in that retirement account after the death of the spouse. This can be complicated by a retirement account that was accumulated prior to marriage or if there is a separate property agreement. If the spouse has a retirement account of their own, then this problem is even worse and much of the estate will be subjected to unnecessary tax burdens.

If you name someone other than your spouse as a beneficiary, like a child, and you don’t have any planning, there are all sorts of problems that could arise. For instance, if the child remains a minor after your death, then the retirement account will require a guardian and the account will have to be monitored until the child reaches of majority age.

Also, whomever takes over monitoring the retirement account will have to figure out for themselves whether an inherited retirement account can be set up and the benefits of setting this sort of account up for the beneficiary remain available despite the lack of planning. Again, it is best to be able to set things up so your beneficiaries inherit funds in such a way that the withdrawals are stretched over the longest period possible, thereby deferring income taxes and allowing greater tax deferred or tax-free accumulation.

Ultimately, failing to coordinate estate planning and retirement planning can lead to loss of the very benefits the retirement accounts provide. This essentially means your beneficiaries won't be able to take advantage of compound interest and tax deferment since they'll have to take RMDs and pay income taxes (or worse).

If you have retirement savings in a qualified retirement plan or IRA, we have a solution for you. Ask about our Layaway Payment Plan, which is a pay-as-you-go option for those on a tight budget. If you’d like guidance and assistance with creating a comprehensive estate plan, schedule a strategy session today; we're happy to help.

Matthew Schlau is a co-founding principal of Schlau|Rogers and an estate and business planning lawyer practicing in Orange, San Diego, Los Angeles and Riverside counties. He is a husband, father, blogger, crossfitter, and really good at helping people achieve their goals.

At Schlau|Rogers, we do more than just estate and business planning, probate and trust administration. Our objective is to provide individually-tailored plans that allow you the opportunity to reach your goals, all while minimizing headaches and risk, and maximizing peace of mind.

On our blog, you'll find useful information about estate and business planning, probate and trust administration, as well as some tidbits on personal finance, taxes, and anything else we think will help minimize headaches, worry and risk, all while maximizing peace of mind.

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