Many people do not realize the importance of correctly designating the beneficiaries of their retirement accounts (IRAs, 401(k) plans, etc.). Because retirement accounts are funded with pretax dollars, there can be significant tax consequences when required minimum distributions are taken, depending on the beneficiary named.
The minimum required distributions are calculated based on the life expectancy of the beneficiary, and then the beneficiary pays income tax on those distributions. However, if a trust is named as the designated beneficiary of a retirement account and the designation is not done in the right way, the retirement account will have to be withdrawn over a five-year period.
If the trust that is the named beneficiary is a conduit trust, though, the distributions may be withdrawn over the life expectancy of the beneficiary of the trust. By extending the time period over which withdrawals are required to be made, less income tax will need to be paid on each distribution.
Because of the income tax owed by beneficiaries on minimum required distributions from retirement accounts, this can result in paying both income and estate tax on retirement accounts.
If the owner of the retirement account intends to make some type of charitable gift at death, this double tax can be avoided by naming the charity as the beneficiary of the retirement account and leaving other assets to individuals. Estate tax will not be owed on gifts to the charity, and the charity will not have to pay income tax on distributions from the retirement account. In addition, the individual beneficiaries are then able to receive assets that will not be reduced by income tax.