RETIREMENT ACCOUNTS AS A TOOL FOR LEGACY PLANNING

Along with home equity, one of the largest assets for most Americans is their retirement plan. According to a recent report produced by the Board of Governors of the Federal Reserve, retirement assets have grown from $7 trillion in 1995 to $19.2 trillion in 2012.

While the majority of individuals will likely need the income from these accounts during retirement, others may not as they have accumulated sufficient assets or income from other sources to sustain their lifestyle. However, when an individual attains age 70½, they are required to commence distributions from tax qualified retirement plans (IRAs, 403(b), 401(k) etc.). In many cases, this required minimum distribution (RMD) results in surplus income that only serves to inflate income taxes.

To further exacerbate this problem, the drainage on these accounts may run contrary to the objective of leaving it to their family as intact as possible. Over the years, I have worked with many clients to devise strategies to address this issue.

The first important step to preserve retirement plan assets for the next generation is to periodically monitor and update the beneficiary designation. One of the worst mistakes that can be made is to directly name the estate as beneficiary or leave it to the estate by default, resulting in the loss of a valuable option for legacy planning.

Assuming there are named non-spouse individuals as beneficiaries, upon the death of the account holder, there are a few distribution options available for the retirement plan. The beneficiary may take a full withdrawal that will result in a taxable distribution if the account is not a Roth IRA. Or, if the account holder was not yet subject to the RMD, the beneficiary can extend the distribution from the date of the accountholder’s death to December 31st of the 5th year following their death in order to spread and manage the income tax liability. In any case, if the beneficiary does not have a current need for the funds and wishes to maximize tax benefits, the preferred option may be to transfer the account into an inherited IRA. This account has an RMD that begins the year following the death of the account holder and is due annually based upon the life expectancy of the beneficiary and account value on December 31st of the prior year. This so-called “Stretch IRA” allows the beneficiary to maintain the benefits of tax deferral over their lifetime (tax free benefits if the account is a Roth IRA) but provides full flexibility to liquidate the entire account should that need arise.

Perhaps the optimal way to preserve the assets in a tax qualified retirement plan is to convert it to a Roth IRA. The result of such a conversion is that there is no RMD and, most importantly, distributions are tax free as long as the conversion was implemented at least five years ago and the taxpayer is age 59 ½ or older. The downside of this strategy is that income taxes are currently due on the converted amount and may be prohibitive. However in some cases, taxpayers may have accrued carry forward or unused losses such as unreimbursed medical expenses, net operating losses from an unincorporated business, or losses associated with certain investments such as intangible drilling costs from an oil and gas drilling program. These losses represent deductions that may offset the income taxes due from a Roth IRA conversion and allow this change to be processed without a cash outlay for taxes.

Another asset preservation strategy is to apply the superfluous RMD to purchase a life insurance policy, preferably a survivorship life policy that insures the husband and wife. This policy should be owned by the children or an irrevocable trust to keep the death benefit both income and estate tax free. While the value of the retirement plan will likely decline due to the RMDs, the leverage and tax benefits created by life insurance results in a significant enhancement for these legacy assets.

For individuals concerned about preserving their assets from depletion that would result from a prolonged nursing home stay, the purchase of long term care insurance using the RMD may be the solution. Doesn’t it make perfect sense to use a required distribution from the very account that you wish to preserve?

Another strategy that has been employed is to use the RMD to fund 529 college savings plans. As one of their estate planning objectives, many of my older clients have a strong desire to leave a legacy of funded educational accounts for grandchildren that accomplishes two goals: assisting their often financially strapped children to pay for these future and escalating college costs and creating a legacy to their grandchildren that may continue for years beyond their death.

Retirement accounts are the proverbial double edged sword as they provide tax relief during the accumulation phase while causing tax and depletion angst during distribution. Pro-active planning can turn this dilemma from a noose to a locomotive if thoughtful and measured steps are taken in a timely manner.

Sincerely,

Clifford L. Caplan, CFP®, AIF®


In the News: I was quoted in a Thomson Reuters article on October 11th titled “The Doomsday Portfolio: How to Invest for Default”. In this article, I commented on the benefits of shorting US Treasury Bonds if the US should default on its debt.

Many thanks to all of my clients and others who reached out to acknowledge my quote in the Wall Street Journal article titled “A REIT That Could Bite Back” that appeared on September 28th.

Links for these articles can be accessed on my website.