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The Importance of the Designated Beneficiary for Retirement Accounts

The Importance of the designated beneficiary for retirement accounts IRAs and 401ks in estate planning cannot be overstated. The designated beneficiary form transfers retirement assets from the owner to heirs without going through the probate courts.

A designated beneficiary is a person or trust identified as the payee on the retirement account owner’s death. Plan administrators provide forms for the owner to name or change the designated beneficiary.

A trust is not needed for retirement accounts. However, a trust is an allowed designated beneficiary. The problem with a trust is the plan administrator. Many plan administrators and financial institutions throw obstacles in transferring from a decedent’s trust to heirs.

Identifying individuals as the designated beneficiaries is more expedient and less of a headache. Despite obstacles placed by plan administrators, a trust should be a designated beneficiary when the owner has minor children or a child with special needs.

Money machines

The beauty of retirement accounts such as 401ks and IRAs, is they allow for asset appreciation that is not taxed until money is taken out. However, the federal government does not want this investment to exist forever and never be taxed. The rule of an annual minimum distribution was created for the IRS to tax retirement accounts.

Required minimum distributions

Minimum distributions begin at the age of 72 while living. Each annual required minimum distribution is based on the owner’s life expectancy. IRS actuary tables determine life expectancy for each year of age. The balance of the IRA or 401k is divided by life expectancy in years for the “required minimum distribution.”

If distributions are not taken or are not large enough, the owner will pay a 50% excise tax on the amount not distributed as required. According to the IRS, 20.5% of owners are expected to take only the minimum in 2021. Most people need their retirement money for living expenses and cannot afford the luxury of transferring wealth to their children and grandchildren.

On the first spouse’s death, the surviving spouse “rolls over” the deceased spouse’s 401k or IRA into his or her own IRA. The surviving spouse uses his or her life expectancy for required minimum distributions. Beginning in 2020, distributions for other heirs under the “Secure Act” have become more restrictive.

Inherited RMDs

Prior to 2020, when a 401k or IRA owner died, the beneficiary’s annual required minimum distribution was based on his or her life expectancy. Under the “Secure Act,” the required minimum distribution is now over a ten-year period.

Inherited 401ks and IRAs allow asset appreciation, not taxed until money is taken out. The Secure Act shortens the life of inherited retirement accounts to ten years. Failure to take any distributions, or if the distributions are not large enough, will result in a punishing 50% excise tax on the amount not distributed as required.

Summary

The beauty of retirement accounts such as 401ks and IRAs is that they allow for asset appreciation that is not taxed until money is taken out. The IRS created the rule of an annual minimum distribution to tax retirement accounts. The new tax law limits the life of an inherited retirement account to ten years. A trust is not needed for retirement accounts. But the importance of the designated beneficiary in your estate planning cannot be overstated.

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