Life Insurance or Retirement Trust: What is the best way to hand down your retirement account?

Life Insurance or Retirement Trust: What is the best way to hand down your retirement account?

One big mistake people typically make when putting together their estate plans is to fail to differentiate between their assets by any criteria other than monetary value. This frequently leads people to believe that their house is the best gift that they will give because it is worth the most. In reality, however, your retirement account may be the best gift to receive. The reason? Your heirs can keep your retirement funds in a tax-deferred account and continue enjoying the accelerated compound growth that makes retirement accounts such a great investment.

Typically, people who do develop a more nuanced view of what can be accomplished with a retirement account choose to leverage it in one of three ways: (1) they designate their heirs as beneficiaries through the account provider; 2) they use the funds to buy a life insurance policy for the benefit of their heirs; or (3) they direct the account funds into a “standalone retirement trust,” a special type of trust. Let’s look at the advantages and drawbacks of each.

Designate Beneficiaries

When you set up your retirement accounts, you are typically asked to designate beneficiaries to receive the account assets upon your death. Most people instruct those assets to go to a spouse first, and then to their kids. While this is a very common decision, it has both advantages and disadvantages.

Advantages

  1. Simple
  2. Free
  3. Avoids probate

Disadvantages

  1. No asset protection
  2. No ability to control distributions
  3. Beneficiaries can withdraw funds in full, eliminating tax benefits

Converting your retirement account into life insurance

Life insurance provides a great way to be sure your heirs will have some cash to work with.

Advantages

  1. Gets cash quickly to beneficiaries
  2. Might give you a way to increase the amount of cash or lower the risk of loss before you pass away
  3. Can skip probate
  4. Recipients do not have to pay income tax on funds received

Disadvantages

  1. Not an option if you’re not insurable
  2. Provides no asset protection, unless the funds are directed into a properly drafted trust
  3. The benefits are counted as part of your estate and can result in estate taxes

Running your retirement account through a standalone retirement trust

The other popular way to pass assets to beneficiaries is through a Standalone Retirement Trust. This is a trust that is created for the sole purpose of serving as the beneficiary of the remainder of your retirement account funds. You will appoint a trustee to oversee the distribution of the funds to your beneficiaries in the manner you consider best.

By utilizing a Standalone Retirement Trust you will be able to have significantly greater control over the distributions of your retirement funds.

Advantages

  1. Asset protection
  2. Generation-skipping tax benefits
  3. Protects the beneficiary with respect to government needs-based benefits
  4. Alerts the beneficiary to the tax consequences of an immediate cash out
  5. Allows for the beneficiary’s tax obligations to be stretched over a period of time
  6. Alleviates the need for a court appointed guardian for minor beneficiaries
  7. Allows for successor beneficiaries

Disadvantages

  1. Takes time and effort to set up
  2. Not everyone needs or wants this level of control and complexity

The IRS has very stringent requirements for Standalone Retirement Trusts. Therefore, it is vital that you seek out the assistance of a professional estate planning attorney who is familiar with their complexities and nuances.

Conclusion

Your retirement account provides you with an amazing opportunity to pass wealth on to future generations. Contact The McKenzie Law Firm today to learn how we can help!

Dan McKenzie
Dan McKenzie
dan@themckenziefirm.com

Dan specializes in estate planning, estate administration, and small business counsel. He opened the McKenzie Law Firm in 2013, after spending 10 years as a litigator, seeing what can happen when people fail to carefully identify and mitigate their risks. He is pleased to be raising four kids in the same state where he grew up.