Probably right as you cashed your first paycheck or framed your first dollar of business income, someone told you to start saving for retirement.  For many, fear of running out of money at retirement age, perhaps a time when it may not be possible or desirable to work, will compel participation in a tax deferred retirement plan such as a traditional IRA, 401(k) or 403(b) (referred to here for simplicity as “qualified retirement plan”).  Often an equal motivation is the desire to take advantage of the valuable financial and tax benefits offered by many qualified retirement plans.  It’s no secret that contributing as much of your pre-tax income to a qualified retirement plan as the law allows provides valuable tax savings opportunities.   Not only is income tax on these contributions delayed until actual distribution (presumably, at retirement age), but earnings on these contributions will grow pre-tax, compounding at a faster rate of return than a comparable non-retirement account.  For example, at the end of a 40 year career, funds contributed to a qualified retirement plan will grow to be about 40% larger (net of taxes)1 than funds in a comparable non-retirement account.  To make an already attractive savings vehicle even better, many employers will “match” contributions, adding additional funds to an employee’s retirement plan if the employee contributes a certain amount to the plan.  These benefits will compel many to contribute to a qualified retirement plan even if another source of funds such as a pension, inheritance, investments or business income will sufficiently cover retirement spending needs.

Those who do not need to tap into their qualified retirement plans for their own spending often wonder what to do with their unneeded qualified retirement plans.  It’s quite a nice problem to have—you’ve saved wisely for retirement just as your mother told you, and as it turns out, you didn’t have to.  But there is no need for buyer’s remorse.   Consider using your retirement plan to further your charitable and estate planning goals.  Qualified retirement plans can be a powerful and extremely tax-efficient vehicle for the accumulation and transfer of wealth to worthy charitable organizations, children and grandchildren.  Naming one or more charities as the beneficiaries of your retirement plan will allow the funds in the plan to escape both income and estate tax, maximizing the value of your charitable giving dollars.  Or for the right person, naming a grandchild or a trust for the benefit of a grandchild as the beneficiary of a retirement plan can preserve the powerful tax-deferred growth in the account over multiple generations, creating a valuable legacy for future members of the family.

Gifts of Qualified Retirement Plan Assets During Life:  Mostly a No-No

When discussing what to do with any unneeded asset, it seems logical to discuss simply giving the asset away during life to a loved one or charity.  Generally, retirement plans cannot be gifted during the life of the plan participant without triggering an ordinary income tax liability on all the assets in the retirement plan and a potential penalty for early withdrawal.  One of the exceptions to this general rule is that in some years, Congress has allowed those over 70 ½ to essentially gift a limited distribution from a qualified retirement plan without triggering income tax liability.  This exception, known as the charitable IRA rollover, or qualified charitable distribution (QCD), allows qualified donors to exclude from taxable income (and to count toward their required minimum distributions) certain transfers of retirement plan assets that are made directly to public charities.  The QCD is technically temporary, and Congress decides each year whether or not to extend it.  The QCD has been available every year since 2006, although it is not yet known whether Congress will renew the QCD for 2014.

While options for gifting your retirement plan during life are limited, the options for transferring your remaining retirement plan at death are abundant, although a few winning strategies stand out.  The financial and tax benefits of naming a charity as the beneficiary of your retirement plan upon your death are compelling.  If instead you are committed to providing for grandchildren in your estate plan, naming your grandchildren as the beneficiaries of your retirement plan upon your death can create a tax-deferred legacy gift that could provide supplementary income to your grandchildren for the rest of their lives.

Naming a Beneficiary of Your Retirement Plan:  Some Basics

It is a common misconception that your estate planning documents such as your Will and/or revocable trust will dictate what happens to your retirement accounts upon your death.  Retirement plan assets do not automatically pass pursuant to your Will or trust documents, but instead pass pursuant to a beneficiary designation on file with the retirement plan administrator.  Your beneficiary designations should be consistent with your estate plan, but there are several unique factors that may cause you to think a little bit differently about how your remaining qualified retirement plans should pass upon your death.  Like most assets passing under your estate plan, the value of your qualified retirement plans is included in your taxable estate, and potentially subject to costly estate taxes.  But unlike many assets passing under your estate plan, the funds in your retirement plan are subject to income tax at ordinary income tax rates when your beneficiaries withdraw the funds after your death.  Following your death, your beneficiaries must quickly begin taking these taxable withdrawals (known as required minimum distributions, or “RMDs”), which are calculated based on the beneficiary’s life expectancy.  Together, these income and estate taxes may substantially deplete the value of your qualified retirement plan assets to your beneficiaries.  But not all beneficiaries are created equal.

Ideal Beneficiary:  Your Favorite Charity

For those with large estates, income and estate taxes can leave less than 30 cents on the dollar of the qualified retirement plan for the account holder’s beneficiary.  Naming a charitable organization as the beneficiary of a qualified retirement plan allows the plan to escape both income and estate taxes, allowing 100 cents of every dollar in the plan to benefit your chosen charities.  The plan will escape income taxes because the law allows tax-exempt charities to withdraw unlimited pre-tax funds from a qualified retirement plan without paying income taxes.  In addition, for those who have sufficient wealth to be facing an estate tax at death, the value of a retirement plan passing to charity upon death is deducted from the value of your estate for estate tax purposes, saving the 40% federal and 0-20% state estate tax liability that would otherwise be due on the value of the plan assets.

A Grand Gift for Grandchildren

Thinking of including a gift to your grandchildren in your estate plan?  You may already be aware that a special tax, the generation skipping transfer (“GST”) tax, is imposed on transfers to grandchildren and more remote descendants.  The tax is imposed at a flat rate (40%) on transfers to this grandchild-level generation and is separate from, and in addition to, any applicable estate or gift taxes. Every individual has an exemption from the GST tax that they may allocate to transfers to (or trusts for) grandchildren and future generations in order to shelter gifts during life or at death from this costly tax.  In 2014, the GST tax exemption is $5.34 million and is adjusted for inflation for subsequent years.  For those with sufficient GST exemption remaining upon death, the assets in your retirement plan could be a valuable gift to leave to your grandchildren upon your death.  When a young person such as a grandchild inherits a retirement plan from his or her grandparent, then beginning at the grandparent’s death, the grandchild need only take minimal distributions from the retirement plan each year over his or her expected lifetime.  Other than these minimal required annual distributions, the balance of the retirement funds may remain in the retirement plan, growing income tax free for decades.  Over time, a modest retirement plan could become a significant source of supplementary income for a grandchild.  Although the opportunity for tax deferral is most compelling if the youngest possible beneficiary receives your retirement plan upon your death, there may be many good reasons to name your spouse or children as the initial beneficiaries of your retirement plan during their lives, with your grandchildren receiving your retirement plan assets only upon the death of your spouse or children.  A retirement plan distributed to a grandchild (or child) upon the death of the account owner is often referred to as a “stretch IRA,” as the tax-deferred status of the retirement plan is “stretched” across multiple generations of the family.

Figure 1:  An IRA initially worth only $2 million has provided a robust income stream for a grandchild over her lifetime.2

Figure_1:_IRA_Chart

  • The above chart illustrates the annual required minimum distributions received by both a grandparent (the IRA owner) and a grandchild (the beneficiary of the IRA) over the course of 68 years.
  • Grandparent aged 70 ½, has an IRA worth $2 million in 2014 which earns a 4% annual rate of return.  Grandparent dies at age 82, having received approximately $1.18 million of minimum required distributions from the IRA.  Upon grandparent’s death, grandchild, who is then 27 years old, is named as the beneficiary of grandparent’s IRA.
  • If grandchild lives until age 78, she will receive approximately $7 million (exclusive of taxes) of distributions from the IRA over her lifetime.

Supercharging the Stretch IRA with a Roth IRA Conversion

Converting your qualified retirement plan to a Roth IRA during your life can provide an even greater tax benefit to your grandchildren.  A Roth IRA offers a few advantages over a traditional IRA or other qualified retirement plan.  Distributions from a Roth IRA are not subject to income tax when distributed to either the account owner or his beneficiaries, so long as the distribution is made more than 5 years after the conversion.  A Roth IRA also does not require the account owner to take any required minimum distributions during his life.  Most other retirement plans require the account owner to begin taking minimum distributions from the plan at age 70 ½, a procedure designed to deplete the qualified retirement plan over the course of the account owners’ life.  By not requiring the account owner (i.e., grandparent) to take any funds out of the Roth IRA during his lifetime, the funds in the Roth IRA can be preserved for grandchildren, who will have minimum distribution requirements beginning upon the grandparent’s death.  The disadvantage of converting a retirement plan to a Roth IRA is that the amount of plan assets you convert to a Roth will be included in your ordinary income tax liability, generally in the year you convert.  Although high income earners cannot initially contribute to a Roth IRA, under current law anyone regardless of income may convert certain existing qualified retirement plans to a Roth IRA.  A Roth conversion may not be appropriate for everyone, and a specific analysis of the account owner’s personal circumstances is essential before pursuing a Roth conversion.

Additional Considerations for Minor Grandchildren

What if one or more of your grandchildren are minors?  Does a 10-year old grandchild then control disposition of the retirement account?  Not necessarily.  The retirement plan could be payable upon the grandparent’s death to a trust for the benefit of a grandchild.  A trust may also be desirable for an adult grandchild who is a spendthrift or is facing a divorce or excess debts.  The trust should be carefully structured as a so-called “conduit trust,” which will look through to the age of the oldest trust beneficiary in making required minimum retirement plan distributions.  Further attention should be paid to ensure that the grandchild who is the intended beneficiary of the retirement plan is the oldest beneficiary of the trust.  Otherwise, the retirement plan may need to be distributed much faster than intended, reducing the opportunity for tax deferral.  If numerous grandchildren will benefit from the retirement plan and the complexity of creating multiple trusts seems daunting, consider whether your state’s version of the Uniform Transfers to Minors Act (“UTMA”) may apply.  If so, the retirement plan could be distributed to (and at the direction of) a UTMA custodian for the child without the need for a formal trust agreement.  Although use of a custodianship requires less advance planning than a trust, the grandchild would gain control over the entire retirement plan at an age when many believe grandchildren are not yet mature (usually at either age 18 or 21). 

If you are considering naming your grandchild as your retirement plan beneficiary, it is important to work closely with an estate planning attorney who is well versed in the GST tax and conduit trust rules in order to ensure efficient use of your GST tax exemption. A stretch IRA is not for everyone, and depending on your assets and the size of your estate, there may be other effective ways to use your GST tax exemption. The Brown Brothers Harriman Wealth Planning team would be pleased to discuss this strategy with you and your tax professionals.

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1 Assumes a 40% combined federal and state income tax rate.

2 The hypothetical illustration does not represent the results for any specific investment and does not consider possible changes to tax laws, the impact of inflation, and other risks.