For many of us, our single largest asset is our qualified retirement account, such as a pension, profit-sharing or 401(k) plan. If a significant portion of your net worth consists of retirement plan assets, it’s important to properly integrate their disposition with your estate plan. Surprisingly, improper integration can have a more adverse impact on the amount you leave your heirs than the investment performance of the funds in your retirement accounts.

Integration can help you maximize the amount you pass estate-tax free to nonspousal beneficiaries, such as your children. Because the estate tax exemption is increasing — from $1.5 million to $2 million in 2006 and to $3.5 million in 2009 — there is an increasing chance that you’ll need to use part or all of your retirement plan assets to fund your bypass or family trust. This trust type typically receives property equal to the exemption amount to minimize your federal estate taxes.

Making a proper beneficiary designation is an essential component of your estate plan. If your qualified retirement plan names your living trust as its beneficiary, you may inadvertently accelerate income tax associated with your retirement plan assets at your death.

This typically happens when an improper funding formula is used in your trust instrument. For example, any allocation of your retirement plan assets made pursuant to a pecuniary funding formula — such as a set dollar amount or the smallest amount necessary to reduce estate taxes to zero — will accelerate income tax. Why? Because you have deferred taxation on gains realized within the retirement plan, the plan’s account includes income in respect to a decedent (IRD), and taxation of IRD is triggered by a pecuniary formula. With proper planning, IRD may be triggered only when distributions are made to the beneficiaries.

When reviewing your estate plan, consider whether you must allocate part or all of your retirement plan or IRA to your bypass or family trust to maximize your overall income and estate tax savings. If so, carefully review your beneficiary designations to ensure they are properly integrated with your estate plan.

Founded in Saint Paul in 1943, Felhaber, Larson, Fenlon and Vogt, P.A. has offices in Minneapolis and Saint Paul. With over 55 attorneys, the firm serves clients in the areas of corporate and commercial law, employee benefits, employment law, estate planning, health care, intellectual property, labor law representing management, litigation, real estate, transportation law, and workers' compensation.