Almost everyone has a retirement account (401(k), IRA, or pension), so planning how these funds pass to loved ones is essential. Here are five key points to understand before naming beneficiaries and finalizing your documents.
- Expect income taxes on most inheritances from retirement plans. Unlike life insurance proceeds or many nonretirement assets, funds withdrawn from inherited non‑Roth accounts are “income in respect of a decedent” and are generally taxed to the beneficiary at ordinary income tax rates when distributed.
- Not all plans follow the same payout rules. Employer plans (like 401(k)s and pensions) often impose stricter timelines, frequently requiring withdrawal within five years of the owner’s death, while IRAs may allow longer deferral depending on the beneficiary. Under the SECURE Act, only Eligible Designated Beneficiaries (a surviving spouse, a beneficiary less than ten years younger than the decedent, the decedent’s minor child, or a disabled or chronically ill person) can still use life‑expectancy “stretch” payouts. Most other individual beneficiaries must withdraw the entire IRA within 10 years.
- Be intentional with beneficiary choices and consider a trust when appropriate. Simply naming a spouse then children as contingent beneficiaries often avoids probate, but offers no protection or control. A carefully drafted trust can coordinate distributions, provide ongoing benefits, and add creditor protection. If a trust is used, its design matters: conduit trusts pass IRA withdrawals straight to the beneficiary (less protection but simpler tax treatment), while accumulation trusts can retain withdrawals for stronger creditor protection but may face higher trust income tax rates. Proper drafting is critical to avoid accelerated payout schedules that could force full distribution within five years.
- Inherited IRAs are not bankruptcy‑protected for most beneficiaries. The U.S. Supreme Court held that inherited IRAs are not “retirement funds” shielded from creditors in bankruptcy. To protect what you leave from a beneficiary’s potential creditors or lawsuits, many families use a standalone retirement trust so the account pays into a third‑party trust administered for the beneficiary’s benefit, adding a layer of protection if the trust is properly drafted and administered.
- Get professional guidance to align your plan with the rules. An estate planning attorney can review your plan documents, confirm that beneficiary forms are correct, and, if needed, tailor a retirement trust to comply with SECURE Act payout rules (10‑year rule versus life‑expectancy stretch for Eligible Designated Beneficiaries). Careful setup helps preserve tax deferral where available, avoid inadvertent five‑year payout traps, and ensure your beneficiaries, not their creditors, receive the funds as you intend.
If you would like to learn more, or set up a complimentary estate planning consultation with one of our Madison, Wisconsin estate planning attorneys, please contact us and we can schedule a time to meet.