How to Use Retiree Benefits in Your Client's Plan

Source: Agent's Sales Journal

Today, it is more and more common for an individual's retirement benefits to be one of his or her largest assets. The increased popularity of employer-sponsored qualified plans and individual retirement accounts means some individuals will save more money than they expect to need for retirement. Because these accounts may still hold a substantial amount at the individual's death, the assets require special consideration that must take into account the individual's objectives and the special rules related to retirement benefits.

Planning for retirement assets requires that your clients consider both federal estate and income taxes. Currently, the federal estate tax allows individuals to pass on a certain amount without incurring an estate tax. In 2007, this amount is $2 million. But by taking the appropriate steps, many individuals can avoid most or even all estate taxes. However, all distributions coming from retirement assets, with few exceptions, are subject to income taxes. As a result, even for individuals who can avoid estate taxes, it may be beneficial to plan ahead. Planning will allow a client to consider and discuss the potential income tax liabilities of those distributions and help to ensure that assets are distributed in a manner that the client wishes they would be.

In order to reduce income tax liabilities, the owner of the retirement assets should consider ways to reduce the minimum required distributions (MRDs) that beneficiaries would normally receive. Generally, accounts holding retirement assets require the account owner or the beneficiary to eventually take MRDs from the account. An account owner must begin taking MRDs no later than April 1 of the year following the year he or she attains age 70½. MRDs for an account owner are calculated by dividing the prior year's account balance by a life expectancy factor published by the IRS that is based on the owner's age.

MRD rules also apply to beneficiaries who inherit retirement accounts, but the rules differ in their application from the account owner. One factor that has the greatest impact on how these rules apply is whether there is a designated beneficiary for the account.

The term "designated beneficiary" has a special meaning under the rules relating to retirement accounts. Only individuals, for example, can be designated beneficiaries. The owner's estate cannot be a designated beneficiary, even if individuals are the ultimate beneficiaries of the estate. If the owner has a trust, the trust beneficiaries may be treated as designated beneficiaries if the owner has complied with a number of rules. There may be more than one designated beneficiary so long as the beneficiaries are all individuals.

The designated beneficiary has at her disposal a number of distribution options that can help delay at least some income taxes. First, if the beneficiary is a spouse, she can roll the retirement account over to an IRA. This allows the spouse to use her own life expectancy to calculate MRDs and to possibly delay their commencement date if she is not yet 70½. If the designated beneficiary is not a spouse, the beneficiary will still be able to stretch out the distribution period over her life expectancy.

If there is no designated beneficiary, all assets must be withdrawn in five years. If the account is substantial, a five-year payout will incur substantial tax liabilities at potentially the highest income tax brackets. In contrast, if the account can be paid out over a 30-year life expectancy, the tax consequences will be much more incremental.

A retirement account owner should complete and regularly update his or her beneficiary designation form to ensure the account will be distributed according to his or her wishes. The beneficiary designation form and not the account owner's will govern how the retirement account is distributed upon the account owner's death.

Through careful planning, retirement account owners may be able to reduce the income tax consequences for their beneficiaries and ensure that their assets are distributed as intended. These issues are complicated and should be thoroughly examined in light of the ultimate goals of the retirement account owner. Even if planning is favorable from an income tax perspective, it may not meet the account owner’s objectives for a number of other reasons.