Inheriting a Retirement Plan- Video Transcription

Hello. My name is Kyle Krasa and I’m an estate planning attorney in Pacific Grove, California. I’m certified by the state bar of California, as a legal specialist in estate planning trust and probate law. The purpose of this video is to give you general information about an important aspect of estate planning law so that you can be prepared when working with your own attorney. Watching this video does not establish an attorney client relationship. The law is far more complex and nuanced than can be explained in a few short minutes. As a result, before acting on any of the information contained in this video, you should consult a competent attorney who is licensed to practice law in your community. With that understanding, I hope you enjoy my video and you find it informative. Thank you.

There are two main types of retirement plans. There’s a defined benefit plan and a defined contribution plan. 

Now a defined benefit plan is the traditional type of pension that you typically think of. It’s a traditional type of retirement plan, where the employer promises to pay the employee a certain periodic payment. Usually for the employee’s lifetime. After the employee dies often, there is a benefit for the employee’s surviving spouse, but once both the employee and the employee’s surviving spouse have passed away, usually the benefit will end altogether. There’s nothing that will continue for children or for any other type of beneficiary. Now defined benefit plans are not as common anymore, especially in the private sector. We usually only see defined benefit plans in the public sector. In California. We have PERS for public employees and CalSTRS for public school teachers. Those are the biggest type of defined benefit plans. I’m in California. They’re both public plans. Uh, can’t think of too many private companies that still offer a defined benefit plan. 

Defined contribution plans are the modern types of retirement plans. And those would include, um, IRAs, Roth IRA’s, 401(K) plans would be a defined contribution plan, a 403(b) plan 457(b) plan. Um, and so on, those are the types of defined contribution plans. So when we’re talking about inheriting retirement plans, we’re really only talking about defined contribution plans because there’s really nothing to inherit from a defined benefit plan, and it pays the employee for his or her lifetime. It might pay the surviving spouse of the employee and then that’s it. There’s nothing we can really do with that. We can’t plan it. We can’t leave it to someone in any kind of strategic manner. Defined contribution on the other hand is like an account that belongs to the employee and it’s portable. It travels with the employee. And so it’s an account that belongs to that person and the employee can leave it to whomever they want. They can leave it to their spouse. They can leave it to their children. They can leave it to friends and family members, um, they can do with it, what they want. 

So today’s focus is going to be on defined contribution plans and how those are inherited. Now, before we get into how a defined contribution plan is inherited, it’s important to understand how they work for the employee. How does it work for you while you’re still living? Before we worry about your beneficiaries inheriting these plans from you, let’s remind ourselves about how these plans work for you. 

So let’s picture this triangle as your retirement plan. I’m going to just use an IRA as an example, this will work with a 401(k) or a 403(b) plan or a 457 plan, but just to make things easy, I’m just going to say you have an IRA here and you put some money into the IRA. 

Now, if it’s a traditional IRA and depending upon your tax bracket, you might have gotten a tax deduction for putting the money into the IRA. And then if it grows, hopefully it grows if you have a good investor, if it grows, it’s going to grow in a tax deferred manner. In other words, you’re not going to have to pay income tax every single year. It’s going to grow in a deferred manner and you have the magic of compound interest. Now the rule is, you know, if you wanted to take some of that IRA out to spend it, we’ve got a few issues here. 

One is the general rule behind defined contribution plans. And it’s what my pensions professor in law school used to refer to as “the Goldilocks Rule,” these two principles, we want it not too soon: Don’t take the retirement plan out too soon. And also not too late. We don’t want to do it too late. It’s got to be just right. Just like Goldilocks. What do we mean by not too soon? Well, in general, you don’t want to take any distribution from your retirement plan before you hit the age, 59 and a half. And the reason for that is because the rules want to encourage you to keep it in there until you’re at least 59 and a half. The reason why you have the tax deferral in the amount that’s in your retirement plan is to encourage savings for retirement. So it’s not supposed to be a slush fund that you use to buy a boat or a third car, or go on a fancy vacation. It’s supposed to be safeguarded for your retirement. So there are a few exceptions, but in general, if you take anything out before you’re 59 and a half, you have to pay a penalty on that. 

Now there’s also the not too late rule. You can’t take it out too late. You’ve got to spend it during your retirement. You’re not supposed to build a giant legacy for your beneficiaries. So there’s a certain age at which you have to begin taking what we call Required Minimum Distributions. That age used to be 70 and a half under prior rules. Under current rules, it’s actually age 72. So once you hit 72, you have to start taking required minimum distributions, a certain amount that you must take out when you reach – I’m going to make this 72 a little bit better here. Um, that’s better. When you hit 72, you have a certain required minimum distribution that you have to take out. How you calculate that is you look at the balance of the retirement plan as of December 31st of the prior year and you divide it by your life expectancy. 

So if you ever wanted to know how much longer you have to live, the IRS has life expectancy tables that tell you how many years you have left. So you base it on these life expectancy tables that are published by the IRS. Now, another thing to think about as well is for every dollar that’s taken out, unless it’s a Roth IRA, for every dollar that’s taken out, you have to pay tax. So the game, when it comes to your defined contribution plan, and I know I’m using the term IRA, but I do mean 401(k) and 403(b) and 457 plan. The game is to only take the least amount out possible. Only take the RMD. If you can, if you don’t need the money, don’t take it out for two reasons. One, you have to pay tax every time so the more you take out, the more you’re paying tax all at once. 

And then the more you take out, the less you have that’s in this tax deferred shelter that allows it to grow in a tax deferred manner. So it’ll grow much faster if it’s not taxed every year than if you have it in a traditional account where you are taxed every year, the magic of compound interest here is really quite valuable. So this concept of trying to make your retirement plan last, as long as possible by only taking the minimum amount out and allowing the rest to grow as much as possible, it’s often referred to as a stretch. 

So the game is to stretch the retirement plan as long as possible. Now I should mention that RMDs are not required when it’s your own retirement plan and it’s a Roth IRA. So a Roth IRA, or sometimes they now have some other Roth products that are similar to IRAs. If it’s a Roth, and it’s your own retirement plan, you don’t have required minimum distributions. Your beneficiaries will have required minimum distributions, but you won’t. 

So keeping this in mind, what we want to do is we want to understand how can a beneficiary have the ability to stretch the inherited retirement plan as long as possible. So there are a few things that we want to keep in mind here. And the first thing we have to do is we have to make sure that we follow certain rules when we name our beneficiaries and the IRS has a term. And that term is that the beneficiary should be, what’s referred to as a designated beneficiary. Now this is a term of art. It’s a specific term, and it means a beneficiary who can maximize, um, the stretch out periods on an inherited retirement plan. And sometimes we call this a DB now to be a DB or a designated beneficiary. 

The key, a designated beneficiary is a person, a living, breathing, human being. Or it could be a trust for the benefit of that person, but there are special rules that come into play when we have a trust as a designated beneficiary and that’s the topic of another video I have entitled, “The Retirement Plan Trust,” which you should watch after this video. But we have to have a person. 

Now, when would it not be a person? Well, a designated beneficiary is not for example, your probate estate. So if you don’t name a beneficiary, then often the default is going to be your probate estate. That’s not an identifiable human being, and we’re going to have the minimal amount of stretch out possible instead of a longer period of time. It could be as little as five years after the retirement plan, owner’s death. Everything has to come out. That means taxation has to come out all at once and we lose the tax deferred manner. The tax deferred shelter of the defined contribution plan structure. That’s not good for the beneficiary. A charity is not a designated beneficiary either. Now, if you’re intending to benefit the charity, that’s not a problem. They don’t pay taxes. Anyway, if it’s a tax deductible, uh, tax exempt charity, um, a charity can become a problem if you have a trust for the benefit of a person and for the benefit of a charity, I discuss that in more depth in my other video, entitled, “The Retirement Plan Trust.” So first of all, we know we need to have a designated beneficiary in order to avoid the five year rule so we can stretch it out even more. Now, there are two types of designated beneficiaries. 

The first type is referred to as an eligible designated beneficiary. So we just put an E at the beginning there, and this is a special type of beneficiary. And that beneficiary is able to use, uh, his or her life expectancy. So when it comes to an inherited retirement plan right away, the beneficiary must start taking a required minimum distribution. Um, even if they’re 12 years old. So they can’t wait till they’re 72, when it’s an inherited retirement plan. But if it’s a certain type of beneficiary, they get to use their life expectancy. If it’s a non eligible, designated beneficiary, then those folks have to do everything after withdraw everything within 10 years. Now, 10 years is a shorter period of time than most beneficiaries’ life expectancy will be, but it’s double the five year rule. It’s double what would be if we don’t have a designated beneficiary. 

So simply by naming a designated beneficiary at a minimum, you’re able to double the stretch out period from five years to 10 years. And that’s very valuable. Now, who is an eligible, designated beneficiary, and who’s not? 

Well, the easiest way to define it is let’s tell you who it eligible that designated beneficiary is. And if you’re not one of the five categories of an eligible designated beneficiary, then you’ve got the ten year rule. So who can use, um, their life expectancy? 

Well, number one, the surviving spouse of the retirement plan owner is an eligible, designated beneficiary and can use his or her life expectancy. One thing I want to point out with regard to a surviving spouse is there’s another option only available to the surviving spouse. And that’s called a spousal rollover where the spouse can treat the inherited retirement plan as if it belonged to the surviving spouse from the very beginning, that can have very significant advantages, not only to the surviving spouse, but also to the surviving spouse’s beneficiary. So whenever I have a surviving spouse as a beneficiary of a retirement plan, I always ask myself, do we want to elect into the spousal rollover? And this is something you have to elect into. So it’s something you have to take action for. So if you’re a surviving spouse and you inherited a retirement plan, you should consider a spousal rollover and you can make this spousal rollover at any time. It could be years after the retirement plan owner died. You could do it 10 years later, but that’s something to consider. Not always, but definitely something to consider. 

The second category would be a minor child, um, until age of majority. So in other words, if we have a five-year-old, until that five-year-old reaches the age of majority, that five-year-old child can base, uh, the stretch the retirement plan over their life expectancy. And once they reach the age of majority, it’s going to switch to the 10 year rule. Now child should be taken. Literally it must be a child of the deceased plan owner. It cannot be a niece or a nephew who happens to be a child, a family friend who happens to be a child, a grandchild. It cannot be any of those categories. It must actually be a child of the defined contribution plan owner. That’s the only way that they would qualify as an eligible, designated beneficiary. Otherwise, they’re going to use the ten year rule. 

The third category would be a disabled beneficiary. The fourth category would be, um, someone that’s considered chronically ill, and both of these terms, disabled and chronically ill are defined under federal law. 

And the fifth category would be someone who is not more, not more than 10 years younger, than the deceased retirement plan owner. So like if you left something to your brother who happened to be five years younger than you, because their brother is not more than 10 years younger than you, in that case, your brother would be able to use his life expectancy. 

So it’s important to understand how beneficiaries can inherit retirement plans. And, um, if, if there’s any beneficiary that’s not within these five categories, then they have the 10 year rule, as long as they are a designated beneficiary. 

I hope this is helpful for you to understand how to inherit retirement plans. Please check out my other companion video, entitled, “The Retirement Plan Trust,” to see how these rules are implemented with a trust as a beneficiary of a retirement plan. Thank you.

I hope you enjoyed watching my video. As I mentioned at the beginning, this is not intended to be a substitute for proper legal counsel. Before acting on any of the information contained in this video, you should consult a competent attorney who is licensed to practice law in your community. Thank you.