By ALAN KONDO, CFP, CLU
For many investors, a large percentage of their assets are held in retirement accounts such as 401(k)s and IRAs. These accounts can be ideal for sheltering retirement savings from pre- and post-retirement taxes. However, because these assets are included in the account holder’s gross estate, they can be highly exposed to tax issues in an estate if managed improperly. The combined estate and income taxes owed by beneficiaries could potentially erode much of the value of these assets.
Proper Naming of Beneficiaries
Many errors that could trigger unnecessary taxes and penalties occur around the naming of beneficiaries. Consider these tips to help avoid problems in this area:
● Be sure to have a named beneficiary. Naming no beneficiary, or naming the account holder’s estate as the beneficiary, will trigger the “five-year rule,” which states that retirement plan assets must be paid out immediately or by the end of the five years following the account holder’s death. This means that the retirement assets will be fully taxed over a five year period. Instead, consider naming real persons as beneficiaries and doing a tax-free transfer to a Stretch IRA, explained below.
● Review and update beneficiary designations. Life situations change frequently and those changes can affect your beneficiary designations. For example, many times after a divorce, participants forget to update their beneficiary designations.
● Make sure one or more contingent beneficiaries are named. Without contingent beneficiaries you may face the same consequence as not naming a beneficiary at all – for example, when a primary beneficiary passes away before you do.
Spousal Beneficiaries
Retirement plan assets that pass to a surviving spouse may qualify for the Unlimited Marital Deduction (a tax-free transfer). The surviving spouse may roll over retirement plan assets to an IRA in his or her own name or elect to treat the retirement plan as his or her own. If the spouse chooses the latter option, he or she may defer taking Required Minimum Distributions (RMDs) until he or she turns age 70½.
A surviving spouse may also “disclaim” — or refuse — his or her interest in an IRA. Once disclaimed, the spouse will not receive any interest in the retirement plan and it will pass to contingent beneficiaries (typically children or grandchildren). Distributions to the contingent beneficiaries must then be made under the RMD rules that apply to non-spouse beneficiaries.
Tips for Non-Spouse Beneficiaries
● Unlike a surviving spouse rollover, an IRA inherited by a non-spousal beneficiary must remain in the name of the deceased account holder.
● When you are the beneficiary of an IRA, it may be best to avoid saying “Send me the check!” to the investment management company. Any distribution to a non-spouse beneficiary is a taxable event. To reduce taxes, you may want to create a Stretch IRA and transfer the inherited IRA into this new account. The Stretch IRA can extend the tax-deferred status of IRA assets for multiple generations. Any check delivered by the deceased’s retirement plan trustee should be made payable directly to the Stretch IRA custodian or trustee, NOT directly to the beneficiary.
● A non-spouse beneficiary must begin taking RMDs from the Stretch IRA by Dec. 31 of the year following the year of the account holder’s death.
Other Considerations
An Irrevocable Life Insurance Trust (ILIT) — If the retirement assets are not needed, using after-tax withdrawals from the retirement plan to purchase life insurance owned by the life insurance trust can be a good strategy. It can convert the taxable asset into a tax-free one.
This article offers only an outline; it is not a definitive guide to all possible consequences and tax implications of any strategy. For this reason, be sure to seek advice from knowledgeable legal, tax, and financial professionals.
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The opinions expressed above are solely those of Kondo Wealth Advisors LLC (626-449-7783, info@kondowealthadvisors.com), a Registered Investment Advisor in the state of California. Neither Kondo Wealth Advisors, LLC nor its representatives provide legal, tax or accounting advice.