One financial planning chore that’s easy to overlook is naming a beneficiary for retirement accounts. This is an important area for everyone who invests through a 401(k) plan or an individual retirement account (IRA), and it can be a critical planning point for people with self-directed accounts.
Top financial planners recommend that all investors name beneficiaries for all their retirement accounts. Not only does this ensure that the account assets will be distributed according to the investor’s wishes, but it also can avoid unanticipated tax problems.
Many people believe that distribution of their retirement assets into their estate will save taxes if the value of the estate, including the account assets, is less than the threshold for paying estate taxes ($3.5 million in 2009). According to the IRS, however, distributions from IRAs and 401(k)s into an estate are “income in respect of the decedent” and are taxable to the estate just as they would have been to the account owner. That means the estate must pay taxes on the distribution.
For a tax-deferred, traditional IRA or 401(k), this means income taxes are due on the entire distribution, since no income taxes were paid on the money before it was contributed to the plan. For Roth accounts, taxes are due only on the earnings from any contributions made within five years before the distribution.
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Naming a beneficiary for each account means that the account assets can be rolled over into an “inherited IRA” and distributed over time, spreading the tax burden out over at least five years. Beneficiaries can choose to take distributions from the account over a period of time based on their life expectancy, beginning no later than Dec. 31 of the year after the death of the original account holder. If they don’t make this choice or begin their distributions on time, they have to take all the money out by the end of the fifth calendar year following the account holder’s death. The beneficiary must declare all taxable distributions from the account as income.
In the absence of a named beneficiary, what happens with the assets in your account depends on where you live and what the plan document says. Some plans outline what happens if the account holder dies without a valid beneficiary designation form on file. For example, the plan—and/or state law—may say the account will be distributed to the surviving spouse, or to surviving offspring if there is no surviving spouse, or to the account holder’s parents if there is no living spouse or child. Messy disputes can tie the account assets up in probate, sometimes for years.
Distribution planning for self-directed IRAs
Planning for distributions from inherited self-directed IRAs can be especially tricky, particularly if the plan assets include non-traditional investments like real estate or business interests. In some cases, these assets will generate sufficient income to pay minimum required distributions for several years after the original account holder’s death. In other cases, the beneficiary may choose to liquidate assets in the account (i.e., sell the business or property) and continue to receive the minimum amount each year to avoid a big tax bill. Another option is to distribute the asset without selling it and pay whatever tax is due on its value in the year of distribution. If the assets include shares of the account holder’s business, questions of valuation may arise and the beneficiary would be wise to consult with a lawyer before distribution.
One last word of caution—unless the taxes aren’t important to you or your heirs, don’t rely on your will to designate who should get your retirement plan assets. In some cases, this could result in your retirement accounts going into your estate, causing unintended tax consequences.