Naming Your Trust as BeneficiarySubmitted by Karstens Investments on February 6th, 2018
By Darren Obrecht
As most people look at their retirement plans to benefit them during their retirement years as a source of or a supplement to their income, one area they often overlook is the impact of how those assets pass to their heirs and their potential taxable obligations. How the beneficiary forms are filled out has a significant impact on how those funds can be used by the next generation and the impact of taxation on how long the assets will last. Many people don’t realize that a beneficiary designation takes precedence over a will or trust. The single most common mistake that is made is to name your estate as the beneficiary of your 401k or IRA. If you do so, you’re almost assured to maximize the income taxes that the recipients will pay.
When there’s no living named beneficiary (even if this is done in a will), the entire account balance is taxable over the deceased’s remaining life expectancy. For example, the IRS tables say an 85 year-old will live another 15 years. If that retiree dies at 85, her IRA accounts must be paid out and taxed at an even pace over those 15 years, even if the heirs are in their 50s or younger with life expectancies of 40+ years. Almost certainly, forcing out the money this quickly wasn’t the idea behind their estate plan.
If, instead, the inheritor had been directly named beneficiary of the IRA or 401k, they could “stretch out” the required withdraw- als over their remaining life expectancy. Because this is often 2-3 times longer, the percentage paid in taxes can be much lower than when forced out in larger chunks over fewer years. For many, this pushes heirs into higher income tax brackets–often 10 percentage points higher than necessary.
The second issue is using a trust as the beneficiary of the ac- counts. This can be done but only by using very specific and well thought out language in the documents. The usual intent for using a trust is to exert some control of the assets after death. If the proper language isn’t used in the trust documents then the newly formed trust will be forced to distribute taxable assets to the heirs quicker than what was originally intended. This has a significant impact upon the inheritors and how much of the received assets they get to keep.
The third mistake that is often made is to make charitable be- quests in the will instead of from the fully taxable IRA or 401k as- sets. In most cases, assets that are disposed of by the will are tax free to the heirs because of stepped up basis at death. Use the fully taxable assets of the IRA or 401k to make the charitable gifts instead of the rest of the estate.
These are just a few of the specific issues that arise for those inheriting assets and the tax impact to them. Don’t let these mistakes cause your assets to be consumed by unintended tax treatment!