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CASE # 1Johnson: Estate Planning to Reduce Tax Liability
“Roth” retirement plans are encountered with increasing frequency among estate planning clients, especially since
(beginning in 2010) the availability of Roth “conversions” was extended to high-income individuals.
Naming the “right” beneficiary for a client’s retirement plans is always a very important step in creating an estate plan.
Failing to name the right beneficiary for a traditional retirement plan can cause loss of the “stretch” life expectancy
payout for the benefits, and the resulting acceleration of income taxes (loss of deferral) can be financial detrimental.
Some planners mistakenly conclude that naming the right beneficiary is less important for a Roth plan than for other
plans, because the Roth distributions are income tax free. Therefore if the benefits are “dumped” out of the Roth plan
shortly after the client’s death due to a faulty estate plan there is no great harm, because there is no acceleration of
income tax.
This idea is mistaken. The stakes are actually even higher with a Roth plan simply because distributions from the
Roth plan are tax-free. Thus the longer the assets can accumulate inside the Roth plan, the more tax-free income the
client and his beneficiaries will receive. If the benefits are “dumped” out of the Roth plan shortly after the client’s
death due to a faulty estate plan, then that future tax-free investment growth is gone forever.
When a traditional retirement plan gets distributed immediately after the client’s death due to a faulty estate plan, the
financial damages are a little speculative. It’s true the income tax has been accelerated when it could have been
deferred, but the beneficiaries would have had to pay that tax sooner or later anyway so maybe they are not really
harmed so much. But when an account that was supposed to generate tax free distributions over the beneficiary’s
entire lifetime gets distributed prematurely, the damage is severe. Just compare the value of that tax-free life-long
stream of payments with the present value of an investment fund that will generate taxable income forever and see
the difference.
The moral is: Proper estate planning is even more important for Roth accounts than for traditional plans!
A.Johnson’s problem
Johnson wants to leave some of his assets to charity, some to his wife, and some to his children. He has some
assets in a traditional retirement plan, some in a Roth plan, and some in “outside” (nonretirement) investments.
Which asset should he leave to which beneficiary?
Chart 1, “Choosing a Beneficiary for the Retirement Plan,” suggests that all three of these classes of beneficiary are
“tax-favored” for the traditional plans:
Chart 1: Choosing a Beneficiary for the Retirement Plan
There are basically six possible choices of beneficiary for a traditional retirement plan, three of which are “taxfavored” and three of which are not tax favored. See details next page L
(or a “see-through trust” for young individuals)
(or a “see-through trust” for older individuals)
NOTE: This chart is about income taxes only. It does not cover estate taxes or generation-skipping taxes. The fact
that a beneficiary is (or is not) income-tax-favored does not mean you should (or should not) leave retirement benefits
to him/her. Leave the benefits to the person you want to leave the benefits to. Just be aware in choosing your
beneficiary that some beneficiaries will receive greater after-tax value from those benefits than others.
The same chart applies to Roth IRAs and plans EXCEPT that charity is not a “tax-favored” choice for a Roth IRA or
Box A-1: YOUNG INDIVIDUAL(S) (or a “see-through trust” for young individuals). Young individuals get the benefit of
long-term tax deferral using the “life expectancy of the beneficiary” payout method. This is no advantage, however, if
the beneficiary does not take advantage of the method (because he/she needs or wants the money immediately).
Also, a lump sum distribution may be more advantageous than the life expectancy payout method in some cases. A
see-through trust for young individual beneficiary(ies) gets the same long-term deferral individuals do; however, not
every trust qualifies for this treatment.
Box B-1: OLDER INDIVIDUAL(S). Older individuals (or a “see-through trust” for the benefit of one or more older
individuals) can also use the “life expectancy of the beneficiary” payout method, but receive less advantage from it
because of their shorter life expectancy.
Box A-2: THE SURVIVING SPOUSE. A surviving spouse who inherits a retirement plan from his or her deceased
spouse can elect to treat an inherited IRA as his/her own IRA, or roll over any inherited plan to his/her own IRA or
other eligible plan. This means the spouse can defer distributions until he/she is age 70½, then withdraw benefits
using the Uniform Lifetime Table (which is much more favorable than the Single Life Table); and name his/her own
designated beneficiary for benefits remaining at his/her death, allowing further deferral.
Box B-2: TRUST FOR THE BENEFIT OF THE SURVIVING SPOUSE. A trust for the spouse, even if it qualifies as a
“see-through trust,” must withdraw benefits from the deceased spouse’s plan over the single life expectancy of the
surviving spouse (at best). Unlike the surviving spouse him/herself, a trust for the spouse’s benefit can NOT roll over
the inherited benefits, can NOT defer distributions until the surviving spouse reaches age 70½, can NOT use the
Uniform Lifetime Table, and can NOT extend deferral (after the surviving spouse’s death) over the life expectancy of
the next generation. Thus, leaving benefits to a trust for the spouse may result in income taxes’ being paid much
sooner, and at a higher rate, than leaving benefits to the spouse outright.
Box A-3: CHARITY (or CHARITABLE REMAINDER TRUST). A charity or charitable remainder trust is income taxexempt, thus pays no income tax on any retirement benefits.
Box B-3: YOUR ESTATE. Usually, the reason benefits end up being payable to the participant’s estate is that the
participant failed to complete a beneficiary designation form for the plan. The participant’s estate does not qualify for
“life expectancy of the beneficiary” payout method, is not income tax-exempt, and often is in a higher income tax
bracket than family members. Thus, generally “my estate” is not a good choice of beneficiary. However, there are
cases in which the estate IS a good choice of beneficiary; consult with your estate planning attorney.
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