Contributed by: Nick Defenthaler, CFP®, RICP®
Checking your beneficiary designations each year on your investment accounts is always a wise move. Our team does this before each planning meeting with our clients, and I can't tell you how many times this has prompted an individual or family to make a change. As tax law has continued to evolve and new rules related to inherited retirement accounts have emerged, it's now even more important to be intentional with your beneficiary selections.
Here are my top five tips and considerations when it comes to prudent beneficiary management and selection:
1. Review Beneficiary Elections Annually
As we all know, mistakes happen, and life changes. Kids might now be older and more responsible for making financial decisions, family members you've listed may have passed away, and dear friends you've named as a beneficiary might no longer be part of your life. Let’s look at a hypothetical investor who we’ll call “Sam”. Sam is in his early 70s and had become divorced three years prior. Sam was also less mobile and, as a result, decided he wanted to hire a new adviser who was closer to his home.
His former wife had been named on his retirement account, which had grown to $1M. If Sam didn't take any action of the time of his divorce, his account would go to his ex-wife, and not his two children as he wants. When we identify a beneficiary that needs to be updated, we make sure the client addresses it immediately as that determines who gets that account.
2. Charitably Inclined? Consider Pre-Tax Retirement Accounts
If you have the desire to leave a legacy to charity, naming the charity as a partial or 100% primary beneficiary on a retirement account could be a very smart tax planning move. Unlike an individual, when a charitable organization receives assets from an individual's pre-tax IRA, 401k, etc., the charity does not pay tax on those dollars. Let’s look an at example client who owns a pre-tax traditional IRA ($1M) and a Roth IRA ($500k). She indicates that she wants 10% of her $1.5M portfolio to go to her church, with the remaining amount being split evenly amongst her four adult children.
To accomplish this goal, we’ll name her church as a beneficiary on her traditional IRA for a specific dollar amount of $150,000. The entire bequest would come from the traditional IRA and nothing from her Roth IRA. This amount could be adjusted as needed. By specifically naming the IRA as the account to fund her charitable bequest, more of her Roth IRA will ultimately go to her kids. If the charity received proceeds from her Roth IRA upon death, the charity would still receive the assets tax-free, so it would be foolish to not have more of these assets go to her kids. Assuming each child is in the 25% tax bracket, this move helped to save her estate almost $38,000 in tax.
3. Naming a Trust? Understand the Ramifications
It is common for clients to name their trust as either the primary or contingent beneficiary of their retirement account. However, when naming a trust, it's important to understand the tax ramifications. Irrevocable trusts aren't used as often as revocable living trusts but have a place in certain cases. While irrevocable trusts typically offer a high level of control, the tax rates for these trusts upon the death of the original account owner are much higher than individual rates with much less income.
Revocable living trusts are the most common trusts we see with a client's name listed as a beneficiary (primary or contingent). However, the correct language must be used within the trust to ensure tax-efficient distributions for the beneficiaries of the actual trust (ex., 'see through' trusts). As always, be sure to consult with your attorney on this matter. Our team always wants to collaborate with your attorney and other professionals on your financial team to ensure the right strategy is in place for you and your family.
4. Beneficiaries in Different Tax Brackets: How to Choose
In addition to intentionally identifying which account would be best served to go to a charity, the same rule applies to individuals who find themselves in very different tax brackets. Let's look at a family we'll call the 'Jones Family' as an example. Mrs. Jones is recently widowed and is in her early 80s. She has two adult children: Ryan (51) and Mark (55). All of them reside in Florida, where there is a 0% state income tax. Mrs. Jones' current portfolio value sits at just shy of $1.1M, allocated as follows: $575,000 in a traditional IRA, $300,000 in a Roth IRA, and $200,000 held in an after-tax brokerage account. Her youngest son, Ryan, finds himself in the 12% federal tax bracket, while her older son, Mark, is in the 35% tax bracket. While Mrs. Jones still wants her estate to be split 50/50 between Ryan and Mark, she wants to make sure the least amount of income tax is paid over time on the inheritance her boys will be receiving. To accomplish this goal, we structure her beneficiary designations as follows:
Ryan: 100% primary beneficiary on traditional IRA (Mark 100% contingent).
Mark: 100% primary beneficiary on Roth IRA and after-tax brokerage account (Ryan 100% contingent on both accounts).
Ryan would be subject to Required Minimum Distributions (RMDs) from the Inherited traditional IRA from his mother, and the account must be depleted in 10 years. However, he would only pay 12% in tax on these distributions. If we assume he stays in this bracket for the next decade, Ryan will end up with $506,000 net of tax [$575,000 x .88 (1 – 12% tax rate)] from the account.
Being that Mark is in a significantly higher tax bracket, it would be much more tax-efficient for him to inherit his mother's Roth IRA and after-tax brokerage account. While Mark's Inherited Roth IRA will also carry an annual RMD and must be depleted in 10 years, the RMDs he would be taking would NOT be taxable to him. The after-tax brokerage account would also receive what's known as a 'step-up' in cost basis upon Mrs. Jones' death, thus eliminating any large, unrealized capital gains she had in several meaningful stock positions in her account.
While there is never a 'perfect' beneficiary plan, the one outlined above accomplishes Mrs. Jones' goal in the best way possible. If we had named Ryan and Mark as 50% beneficiaries on each account, the total tax burden on the overall inheritance would have been $66,000 higher, primarily due to Mark paying a much higher tax rate on the RMDs from the traditional IRA. Our plan gives Ryan and Mark' net' the same amount. This means more of Mrs. Jones' estate is staying with her family, and a lot less will be going towards tax.
5. End of Life Tax Planning Strategies
As clients age in retirement, they may spend less money and/or incur large medical costs that would result in significant tax deductions. If the owner of a traditional IRA or 401k finds themselves in this situation, they should closely evaluate completing Roth IRA conversions (full conversions, a single partial Roth conversion, or partial conversions over the course of several years).
When converting funds from a traditional IRA to a Roth IRA, the converted funds are considered taxable income. In general, a conversion only makes sense if the rate of tax paid today on the conversion will be less than the tax rate on distributions in the future (either by the current account owner or a future beneficiary). If an individual or family is spending much less and is now well within the 12% bracket, it could make sense to complete annual Roth conversions to completely 'fill up' this low bracket. Another common occurrence that clients might experience is large medical deductions. Unfortunately, these tax deductions ultimately either go to waste or are greatly diminished because there is not enough taxable income to offset the deduction. I have seen scenarios where clients could have converted $30k+ to a Roth IRA completely tax-free due to a large medical deduction. However, the deduction essentially went to waste because no income was generated on the tax return for this deduction to offset. In a sense, this is like striking a match to free 'tax money'. Keep in mind that inherited IRAs cannot be converted to one's own Roth IRA or an Inherited Roth IRA, so exploring conversions during the original account owner's life is imperative. Roth conversions will not make sense for everyone, but when they do, the potential tax dollars saved can be massive.
Naming beneficiaries and having a clear understanding of how you would like funds allocated is step one. Once this is known, the job is usually not complete. A quality adviser who has extensive knowledge of tax planning should be able to offer guidance on how to accomplish this goal in the most tax-efficient manner possible. As mentioned previously, collaboration with other professionals on the client's financial team (ex., CPA and attorney) is ideal. Doing so could allow more of your hard-earned money to stay in the pockets of those you care most for and less going to the IRS!
Nick Defenthaler, CFP®, RICP®, is a Partner and CERTIFIED FINANCIAL PLANNER™ professional at Center for Financial Planning, Inc.® Nick specializes in tax-efficient retirement income and distribution planning for clients and serves as a trusted source for local and national media publications, including WXYZ, PBS, CNBC, MSN Money, Financial Planning Magazine and OnWallStreet.com.
Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Center for Financial Planning, Inc is not a registered broker/dealer and is independent of Raymond James Financial Services Investment advisory services are offered through Center for Financial Planning, Inc. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Nick Defenthaler, CFP®, RICP® and not necessarily those of Raymond James.
Raymond James and its advisers do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.
These examples are hypothetical illustrations and are not intended to reflect any actual outcome. they are for illustrative purposes only. Individual cases will vary. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Prior to making any investment decision, you should consult with your financial advisor about your individual situation.