Estate Planning and Your Retirement Accounts
For many people, retirement accounts, including 401(k) plans and individual retirement accounts (IRAs), are their most significant assets. While you may think you'll need every bit of money in those accounts for your retirement, what would happen if you die at an early age? You should include these accounts in your estate plan so heirs inherit them with minimal estate- and income-tax effects. Some strategies to consider include:
• Review your beneficiary designations. These assets are distributed based on beneficiary designations, not your will or other estate planning documents. Thus, you should name primary as well as contingent beneficiaries. Make sure you understand how your assets will be distributed if a primary beneficiary dies before you do. For instance, if your primary beneficiaries are your children and one child dies before you, do you want that child's share to go to your remaining children or to that child's children? Review your beneficiary designations after major life changes, such as marriage, divorce, or a child's birth.
• Consider rolling your 401(k) plan assets over to an IRA. Now that 401(k) plans must allow nonspouse beneficiaries to withdraw funds over their life expectancy, there is not as much need to roll 401(k) plan assets over to an IRA. However, with IRAs, you will often have many more investment options for your plan assets. Also, you may want to roll the plan assets over to a Roth IRA, but will first need to roll over to a traditional IRA (see below).
• Split an IRA when there are multiple beneficiaries. When there is more than one nonspouse beneficiary for an inherited IRA, distributions must be taken over the oldest beneficiary's life expectancy. By splitting the IRA into separate accounts, each beneficiary can take distributions over his/her life expectancy. You can split the account while you are alive, or your beneficiary can do so within nine months after your death. Separating the account is especially important when one of the beneficiaries is not an individual or qualifying trust, such as a charitable organization. If you die before required distributions begin at age 70 1/2, the entire balance must be paid out in five years. If you die after required distributions begin, the balance must be paid out over your remaining life expectancy. When the account is split, the individual beneficiary can take distributions over his/her life expectancy.
• Make sure your spouse understands the rules for inheriting an IRA. Your spouse should be careful not to roll the balance over to a spousal IRA too quickly. Once the balance is rolled over, some planning opportunities are lost. For instance, spouses under age 59 1/2 can make withdrawals from the original IRA without paying the 10% federal income tax penalty. Once the account is rolled over, withdrawals before age 59 1/2 would result in a 10% federal income tax penalty. Also, spouses who are older than the original owner can delay distributions by retaining the IRA. The surviving spouse does not have to take distributions until the deceased spouse would have attained age 70 1/2, even if the surviving spouse is over that age. The spouse may want to disclaim a portion of the IRA, which must be done within nine months of the original owner's death. If the account is rolled over, that disclaimer can't be made. Thus, it is usually best for the surviving spouse to determine his/her financial needs before rolling over the IRA balance.
• Consider rolling your traditional IRA balances over to a Roth IRA. Starting in 2010, all taxpayers can now convert from a traditional IRA to a Roth IRA, regardless of income levels. You must pay income taxes on the taxable amount of the conversion, but those taxes can be paid with funds outside the IRA. That preserves the IRA's value and reduces your taxable estate. Then, your heirs will receive qualified distributions free from income taxes, including all future appreciation on the balance.
• Teach your heirs the benefits of stretching out withdrawals from inherited IRAs. After an IRA is inherited, a traditional deductible IRA still retains its tax-deferred growth and a Roth IRA retains its tax-free growth. Your heirs should extend this growth for as long as possible. If the IRA has a designated beneficiary, which includes individuals and certain trusts, the balance can be paid out over the beneficiary's life expectancy. Spouses have additional options which can stretch payments out even longer. Your heirs can elect to take the entire balance immediately, paying any income taxes due. Make sure to stress to heirs the importance of taking withdrawals as slowly as possible.