After your divorce is finalized and the various accounts divided and settled, you will be able to update your beneficiaries. Assuming your partner or spouse was previously your primary beneficiary, you’ll need to update all retirement plans to properly pass assets to your heirs. While this sounds simple, it involves more complex laws, regulations, and financial infrastructure than you might anticipate.
In this post, we detail what to consider when choosing beneficiaries, important legislation that impacts your decision-making process, and how to create a plan that works best for you and your beneficiaries.
SECURE Act of 2018
Before we get into factors you might consider when choosing beneficiaries, it’s important to understand a recent law that impacts your planning: the SECURE Act of 2018.
Prior to the SECURE Act of 2018, non-spousal beneficiaries had the ability to withdraw funds from their inherited retirement accounts in any way they chose, as long as a required dollar amount was withdrawn each year. This required amount was known as the required minimum distribution (RMD). The RMD was calculated on an annual basis and took the life expectancy of the beneficiary into consideration. Therefore, the beneficiary had the opportunity to ‘stretch’ withdrawals over their lifetime allowing assets to grow over a long period of time from tax-deferred growth. This essentially increased the overall inheritance while minimizing tax consequences.
After the SECURE ACT of 2018 went into effect, regulations for non-spousal beneficiaries changed and became more complex. The new rules require all non-spousal beneficiaries to completely liquidate the inherited retirement account(s) within ten years of the original owner’s death. There is no annual required amount that must be withdrawn; however, the balance of the account(s) must be zero dollars within ten years. Any withdrawal made from a pre-tax retirement account (such as a Traditional IRA) is 100% taxable to the beneficiary. Therefore, withdrawals could potentially bump your beneficiary(s) into a higher tax bracket, significantly increasing the overall tax due on the accounts overall and lessening the total amount inherited.
There are some exceptions to the new structure where the old ‘stretch’ law method still applies to:
- Disabled individuals
- Chronically ill individuals
- Individuals who are less than ten years younger than the original account owner. This situation might apply if the beneficiary was a sibling, cousin, or friend.
- Minor children. Minor children will be able to stretch withdrawals over their lifetime until they reach the age of majority, which is 18 in Colorado. After they reach that age, they will be required to withdraw the remaining funds in ten years.
- Some trusts. If you currently have a trust with a named beneficiary, speak with your estate attorney to determine if it meets the requirements to ‘stretch’ the withdrawals over your beneficiary’s lifetime.
Factors that Influence Beneficiary Planning
As you can see, following the SECURE ACT of 2018, account holders are putting more thought and strategy into beneficiary planning due to the complexity of the updated law. Many work closely with financial experts who can help them make decisions on beneficiary planning for their unique situation.
As you determine who to choose as your new beneficiary(s) post-divorce, it is critical to consider the following factors:
- Your relationship to the beneficiary
- Your age (as the account holder)
- The age of the beneficiary
- The type of retirement account (pre-tax or post-tax)
- The amount of money that will transfer to your beneficiary
- The financial situation of the beneficiary.
While there are families and situations where the change in legal landscape won’t significantly affect the beneficiary’s overall outcome. However, other families and individuals may be impacted by these changes. Some of the most impacted beneficiaries are those who receive enough inheritance that they move into a higher tax bracket and receive increased tax bills.
Creative Financial Solutions
If you believe your beneficiaries will be fairing well financially at the time of the inheritance and therefore would prefer deferring withdrawals to grow the inheritance, there is a possible solution to ‘stretch’ withdrawals over a non-spousal beneficiaries’ life.
With the help of an experienced estate attorney, a trust can be drafted that meets the various IRS requirements. The trust itself can be named the primary beneficiary of the retirement account (instead of the beneficiary outright). When this workaround is in place, the stretch laws can be utilized over the beneficiary’s lifetime, as they were before the SECURE ACT of 2018. Designing your beneficiary plan in this way provides your heirs with significant long-term growth potential and gives you peace of mind that their inheritance won’t have unintended tax consequences.
At A.M. Financial, we can help you design a post-divorce beneficiary plan that provides the maximum amount of inheritance to your heirs while minimizing the tax consequences. A Certified Financial Divorce Analyst, Amy Mahlen can provide the guidance you need to choose your beneficiaries and design a plan that works for your family’s unique situation. Contact us to learn more.