You and other Americans like you have accumulated an estimated $11 trillion of wealth in retirement plans. That’s $2 trillion more than the total market value of all publicly traded U.S. stocks and significantly greater than the $4.5 trillion in total bank deposits reported by the Federal Reserve. Source: Judy Diamond, Journal of Financial Service Professionals, July 2003.
For many of us, individual retirement accounts can be one of our major assets. They include 401(k)s, 403(b)s, Roth Individual Retirement Accounts, self directed Individual Retirement Accounts, Keoghs and SEPs.
We spend a lot of time deciding what to invest in and how to make our 401(k)s and IRAs grow while we are living. Few of us understand the rules and complexities associated with our choices of beneficiaries and their choices when we die. These choices have a huge impact on the long term value of your tax deferred retirement account.
The rules regarding the withdrawal and distribution of inherited retirement accounts are complex. If your beneficiaries don’t correctly follow the rules in establishing inherited IRAs, the ability to stretch the tax deferred benefits from the account will be lost. If they don’t pay any necessary required minimum distributions (“RMDs”), they may be subject to a 50% IRS penalty.
What rules manage your retirement accounts?
What is the difference between a pre-tax and a post-tax retirement plan?
Can you decide when your beneficiaries will withdraw the funds they inherit?
How can you and your beneficiaries maximize the value of their inherited retirement accounts?
Why would you establish a trust as the beneficiary of your retirement account?
Why should you not name your “estate” as the beneficiary?
Your retirement accounts are your self funded pension. Congress created the rules on how your retirement accounts work. The Internal Revenue Service wrote guidelines on how and when to contribute or withdraw distributions in accordance with federal guidelines.
The rules and regulations your beneficiaries must follow for inherited retirement accounts are not managed by your will or living trust. They are governed by a series of complex Internal Revenue Service (IRS) rules dictating the manner and degree to which beneficiaries access the retirement accounts they inherit. Yes, the same IRS which oversees your federal income tax returns.
Think of these retirement account laws as creating a special will directing what happens to your IRA assets. A will you didn’t write. A will managed by IRS guidelines and new rulings from the IRS on what the guidelines really mean.
Understanding your beneficiary options and the consequence on the long term tax deferred value of your retirement accounts is essential. If you make a mistake, or your beneficiary makes a mistake, the IRS penalties are harsh and costly.
Different states have different laws regarding the process necessary if you want to name someone other than your spouse to inherit your retirement accounts. Further, states differ in their treatment of the income generated from IRAs.
When you open a retirement account, you sign a contract with the custodian. Your retirement account is then managed according to the terms of the agreement between you and your custodian. If you are employed and contributing to a 401(k), the custodian is usually your employer. For example, if you have a self directed IRA account at Charles Schwab, Charles Schwab is the custodian.
Although the IRS provides guidelines on how a retirement account should operate, the custodian agreements may be different from one custodian to another. You should read the custodian agreement very carefully.
- You may find the agreement includes language designating a default beneficiary, otherwise known as a “contingent beneficiary”, who inherits your retirement account if (a) your designated beneficiaries die before you, (b) you have designated your estate as the beneficiary, or (c) your designated beneficiary dies at the same time you do.
- The agreement may also include default language regarding whether your beneficiaries inherit on a per stirpes or per capita basis. You may find the default provisions don’t match your own beneficiary preferences.
- Although new laws permit non-spouse beneficiaries of 401(k) accounts to set up inherited IRAs, not all 401(k) custodian agreements offer this option.
We have provided a few questions and answers about naming beneficiaries for retirement accounts and inherited retirement accounts in the charts below.
We highly recommend that you, your designated beneficiary and your executor or trustee visit someone with specialized knowledge about inherited retirement accounts before finalizing your beneficiary choices and before your beneficiaries open up their own inherited retirement accounts. Once a beneficiary has made a choice, the IRS generally does not allow you to go back.
Your beneficiary has the choice to immediately withdraw the money or stretch the payout of your retirement account to successor beneficiaries. The longer your retirement account can continue to grow in its tax-deferred state, the bigger its benefits. When making a choice between a 401(k) or a Roth IRA, be sure to consider the after death value to your beneficiaries.
Before finalizing your choice of a Roth IRA versus other choices or selecting your beneficiaries, visit www.diesmart.com. You can see the long term value of these accounts based upon the taxable nature of the distributions, your choice of beneficiaries and their life expectancy factor.
Pre-tax retirement plans.
401(k)s, 403(b)s and Individual Retirement Accounts (IRA) are funded with pre-tax contributions. You earn $10,000 in 2008 and you contribute $1,000 to your retirement account. You deduct the $1,000 of retirement contributions from your taxable income. You report taxable income of $9,000 on your Form 1040 tax return and you pay income taxes on $9,000. The $1,000 is considered a pre-tax retirement contribution.
At the age of 70 1/2, the account owner must begin taking distributions from the account, referred to as the Required Minimum Distribution (RMD).
The distributions are reported as ordinary income on your 1040 tax return and any applicable federal and state income taxes must be paid.
Post-tax retirement plans.
Roth IRAs, Roth 401(k) and Roth 403(b) retirement accounts are funded with post-tax contributions. You make $10,000 a year in 2008 and you contribute $1,000 to your retirement account. You report taxable income of $10,000 on your Form 1040 tax return and pay income tax on the entire $10,000. Your retirement contributions were made with money you had left after paying any federal and state income taxes due. The $1,000 is considered a post-tax retirement contribution.
The original account owner is not subject to any required minimum distributions. In fact, the earnings in a post- tax retirement plan may grow tax deferred until the owner dies.
The distributions are not considered as income and no federal income tax is due on the distributions.
Q. Can you determine when your beneficiary withdraws funds from his inherited retirement account?
A. Unless you set up a trust for managing your retirement accounts, your beneficiaries are in control of when they withdraw the funds.
Option 1: A beneficiary can immediately withdraw the entire balance of your retirement accounts and pay any taxes due.
Option 2: A beneficiary can withdraw the entire amount over a 5 year period and pay any taxes due.
Option 3: A beneficiary can set up an inherited IRA account and stretch the tax deferred nature of your accounts.
Option 4: A surviving spouse beneficiary can roll over the accounts into their own.
Q. How can you and your beneficiaries maximize the value of their inherited retirement account?
A. Your beneficiary may have the option of setting up an inherited IRA account and “stretching” the tax-free distribution of the funds over a period of time, referred to by the IRS as his or her ”life expectancy factor”. Your beneficiary can name a “successor beneficiary”, someone who will inherit the same rights and privileges as the original beneficiary should the original beneficiary die.
A. You can control when a beneficiary can withdraw the funds.
- If you want to maximize the value of a stretched IRA, consider setting up an IRA trust. The instructions in the trust will provide that the distribution of income from your IRA to the beneficiaries will be stretched. The beneficiaries cannot immediately cash out the account, which is then held in trust. If you just name an individual as the beneficiary, that individual can elect whether to immediately cash out the account or set up an inherited account.
- If the beneficiary is a minor child, the trustee can name a custodian who will manage the money on behalf of that child.
- You may want to control the second inheritance of the account. If you are in a second marriage, you may want to give your spouse distributions from an inherited retirement account while he or she is living, but control who inherits the accounts when he or she dies. In contrast, if you name your spouse as the primary beneficiary, the spouse will also inherit the right to determine who receives distributions when he or she dies.
Be sure and consult an attorney with knowledge in this area. The IRA trust needs special language identifying the beneficiaries. If the IRS does not believe the trust meets its requirement for naming beneficiaries, the trustee must take a lump sum distribution of the assets or pay out all of the funds within a five year period.
Q. Why should you not name your “estate” as the beneficiary of a retirement account?
A. Naming your estate as the beneficiary of your IRA, or having the estate become the beneficiary because there is no living named beneficiary, has a variety of consequences.
A named beneficiary has an immediate right to distribute the retirement assets upon your death. When the beneficiary is the estate, the account is a probate asset and will be subject to the same delays, costs and processes as other assets that are being probated.
Most custodial agreements provide that if an owner dies without naming a beneficiary of their account, the account beneficiary is the owner’s estate. In such a case, the account beneficiaries will be the heirs of your estate determined by your will or, if you don’t have a will, state intestate statutes. However, some IRA custodial agreements contain language that, in the absence of a named beneficiary, upon the owner’s death the account money belongs to a spouse, then to surviving children, before the estate becomes the beneficiary.
The beneficiaries determined by a will (or laws of intestate succession) lose their right to “stretch” the payout of the retirement account. They must either withdraw all of the funds within five years or use the life expectancy factor of the original owner of the retirement account.
If the beneficiary of a traditional IRA is determined by a will or intestate succession laws, these rules apply:
- If the deceased original owner of the account was over the age of 70 1/2 and was already taking required minimum distributions, the beneficiary determined by the owner’s will (or state intestate succession laws) assumes the life expectancy factor of the original owner based on the IRS Single Life Expectancy Table.
- If the owner dies at the age of 80, the new beneficiary inherits a life expectancy factor of 10. The beneficiary must withdraw all of the money within 10 years of the year of the original owner’s death.
- If the deceased original owner was under the age of 70 1/2 and was not taking required minimum distributions, the new designated beneficiary must withdraw all of the funds by the end of the fifth year following the year of the owner’s death. No distribution is required for any year before that fifth year.