401K and IRA Considerations that May Influence the Estate Planning Process


Many people accumulate significant benefits in qualified employer benefit plans such as 401Ks and individual retirement accounts (“IRAs”). These benefits are subject to a maze of tax rules. Both the participants and their beneficiaries need advice on the plethora of choices they face. This article focuses primarily on those features of qualified plans and IRAs that influence the estate planning process.
General Background Information
Qualified plans can offer income tax advantages on various levels. A “qualified plan” means a plan that meets the requirements of Internal Revenue Code Section 401. For purposes of this article, it does not include plans of governments and other tax-exempt entities, which are subject to special rules. It also does not include nonqualified executive compensation plans. Employer contributions to a qualified plan are generally deductible by the employer when the contributions are made. Employee contributions may or may not be permitted by the plan. If employee contributions are permitted, they may be made with pre-tax or after-tax dollars, depending on the type of plan and the terms of the plan. All contributions are subject to certain overall limits.
Qualified plan assets are generally kept in a qualified trust. Some Section 401 plans are kept in custodial accounts that are treated as trusts for purposes of the taxation of the accounts. Qualified plan trusts are not subject to income tax, except to the extent that they have unrelated business taxable income.
Qualified plans fall into one of two general categories: defined contribution plans and defined benefit plans. A defined contribution plan has a separate account for each participant. The amount of the contribution that will or can be made to the plan determines what will or can be held in the account. The amount of distributions that the participant or beneficiary will receive depends on the amount which is in the participant’s account. The investment performance of the account therefore has a significant effect on how much the benefits from this account will ultimately be. Defined plans include all other qualified plans. A defined benefit plan promises each participant a specified defined benefit. Contributions are targeted to fund the total benefits promised. Thus, the investment performance of the plan assets generally has no effect on how much the participant ultimately receives, except to the extent that the plan has insufficient funds to pay the promised benefit.
Individual Retirement Accounts and Treatment of Individual Contributions
Virtually any individual who receives compensation for personal services may establish his own IRA. All contributions must be made in cash. The individual’s employer can contribute to an individual’s IRA under certain circumstances. An IRA is not generally subject to income tax on its earnings. Therefore, even if a contribution is not deductible, the earnings on that contribution will be tax-free as long as they remain in the IRA, except to the extent of the IRA’s unrelated business taxable income.
Roth IRAs
An individual can contribute up to $7,000 per year or $8,000 for those who are 50 or older to a Roth IRA. Unlike regular IRAs, there is no age limit for making contributions. Contributions, however, are not deductible. Further, no contributions to a Roth IRA are allowed if AGI exceeds $161,000 for a single person or $240,000 for spouses filing jointly.
Distributions are not taxable if they are attributable to contributions held for at least five taxable years, and are made (1) at or after age 59 1/2; (2) after the death or disability of the contributor, (3) for “first-time homebuyer expenses.” (First-time home buyers can withdraw up to $10,000 without penalty or taxes to purchase a first home, or (4) for qualified education expenses, certain emergency expenses, or qualified expenses related to a birth or adoption.
IRAs Versus Qualified Plans
There are significant differences between IRAs and qualified plans. These differences become a matter of particular concern when a participant is considering whether to roll over a qualified plan distribution into an IRA.
Borrowing From the IRA or Qualified Plan
Neither the participant nor related party can borrow from the participant’s IRA, use the IRA as security for a loan, or otherwise engage in certain self-dealing transactions with the IRA without causing the entire IRA to be deemed distributed. A qualified plan may permit the participant to borrow from the plan, subject to certain limitations. Certain dealings between the plan and the participant, however, may be prohibited transactions that can result in a distribution and the assessment of income tax and excise tax.
Holding Life Insurance Policies
Life insurance cannot be held by an IRA. A qualified plan may or may not be able to hold life insurance. A qualified plan can hold life insurance policies on the participant, his estate, or a named beneficiary under certain circumstances. The general rule is that the death benefit provided through insurance held by a qualified plan must be “incidental” to the plan’s primary retirement benefit. These “incidental benefit” rules limit the percent-age of employer contributions that can be used to purchase life insurance.
Depending on the source of the premium payments, life insurance held in a plan for the benefit of the participant’s estate or his beneficiary may cause current income tax consequences to the participants. Specifically, the participant will have current taxable income if premiums are paid with (1) contributions that are deductible by the employer, (2) income earned by the plan, or (3) amounts attributable to deductible or pre-tax employee contributions. To the extent premiums are paid with after tax employee contributions, however, they are not subject to current income tax. When a life insurance contract is distributed to a plan participant, the participant is taxed on the excess of the cash surrender value of the policy at the time over his or her basis. If the participant wants to roll over assets to an IRA, he or she would have to sell or surrender the policy and roll over the proceeds because an IRA cannot hold a life insurance policy.
Plan Investments
A participant in an IRA can have extensive input regarding the investment of the IRA assets. In contrast, a participant in a qualified plan may have limited or no control over the investment of the plan assets, although many defined contribution plans allow participants to select from a range of investment options.
Investment in Collectibles
An IRA cannot invest in collectibles. “Collectibles means work of art, rugs, antiques, metals, gems, stamps, certain coins, alcoholic beverages, musical instruments, historical objects, and any other tangible personal property deemed a “collectible” by the IRS. See IRC Section 408(m)(2); IRC Section 408(m)(3). A qualified plan can generally make these investments, except in a self-directed account. In the case of a self-directed account, an investment in collectibles is treated as a distribution.
Estate Taxation of Interests in Plans and IRAs
A participant’s interest in his qualified plan or IRA is generally included in his estate for estate tax purposes. This fact, combined with the fact that the participant’s interest continues a right to income in respect of a decedent (“IRD”), makes qualified plans and IRAs poor vehicles for passing wealth on to succeeding generations.
Qualification for Marital Deduction
Benefits payable out of qualified plans and IRAs qualifying for the marital deduction if they are payable in a qualified form. Qualified plan or IRA benefits that are payable outright to the surviving spouse in a lump sum will qualify for the marital deduction. If the surviving spouse can choose whether to take the benefits in a lump sum or otherwise, and elects to receive a lump sum or directly roll over the benefits to an IRA, the benefits would qualify for the marital deduction. What if a surviving spouse has the option to take the benefit in a lump sum, but irrevocable chooses a different form of payout? If the payout is a qualified survivor annuity, the marital deduction should be available. Even if it is not a qualified survivor annuity, however, the marital deduction should be available. (a marital deduction allows one marriage partner to transfer an unlimited amount of assets to their spouse without incurring a tax).
Qualified Plans and IRA as Wealth Transfer Vehicles
Qualified plans and IRAs can be wonderful for the lifetime of the participant and his or her spouse. However, they are not good vehicles for transmitting wealth to the rest of the family because of their status as a right to receive IRD (untaxed income that a decedent had earned or had a right to receive during their lifetime). An IRD item will be exposed to both income and estate tax.
Ten Percent Penalty Tax on Early Distributions
In general, an early distribution or early withdrawal is a distribution before the participant reaches age 59 ½. A plan or IRA may or may not permit early withdrawals. Subject to certain exceptions, any early distributions are subject to a penalty tax of ten percent of the amount included in income. The relevant exceptions include:
- A withdrawal made after the death of the participant;
- A withdrawal attributable to the participant’s disability;
- Distributions up to $5,000 per child for qualified birth or adoption expenses;
- Corrective distributions of excess contributions;
- Total and permanent disability of the participant or IRA owner;
- Up to $22,000 to qualified individuals who sustain an economic loss by reason of a federally declared disaster where they live;
- A distribution to a victim of domestic abuse by a spouse or domestic partner, up to the lesser of $10,000 or 50% of the account;
- A distribution made to an alternative payee under a Qualified Domestic Relations Order;
- In the case of an IRA, a distribution made for qualified higher education expenses;
- One distribution per calendar year for personal or family emergency expenses, up to the lesser of $1,000 or vested account balance over $1,000;
- A withdrawal that is part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the participant or the joint lives or joint life expectancies of the participant and his designated beneficiary after the participant has separated from service, provided the annuity is not modified;
- A withdrawal made to pay certain medical expenses;
- A withdrawal made after the participant has separated from service and attained age 55;
- A withdrawal made on account of a Section 6331 levy on the plan by the IRS.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
