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Be Careful About Picking Beneficiaries for
Your IRAs and 401(k)s
Inheriting IRA or 401(k) proceeds from a friend or relative
can be a potentially huge windfall, but it can also be a sizable
tax headache. For both the giver and the recipient, it's worth
getting some advice.
Bank accounts, stocks, real estate and life insurance
proceeds generally pass to heirs free of income tax. However,
inherited retirement benefits can be a different story.
Beneficiaries have to pay ordinary income tax on distributions
from 401(k) plans and traditional IRAs after they are inherited.
(You don't see the same problem with Roth IRAs — their benefits
can be free of income tax to your heirs if all tax requirements
are met.)
A financial planning professional or an experienced tax
advisor can work with you based on your personal tax and estate
circumstances to determine an inheritance strategy that is best
for you. Some general guidelines:
Spouses are the first stop. Federal law dictates that
your surviving spouse must be the primary beneficiary of your
401(k) plan benefit unless your spouse signs a waiver to
redirect those funds. Even with a traditional IRA, naming the
spouse as the primary beneficiary may be an appropriate option.
Should the surviving spouse have his or her own IRA, this
approach would allow them to simply roll over the assets from
the decedent's IRA into their own.
Furthermore, if the surviving spouse is significantly younger
than the deceased, the surviving spouse would receive the added
benefit of stretching out distributions from the IRA until he or
she turns 70 1/2. The stretch-out allows the assets to continue
to grow on a tax-deferred basis, thereby maximizing asset value
and delaying any income tax due.
When might you want to rethink a spousal beneficiary?
When the surviving spouse's estate is expected to be large
enough to exceed the applicable exclusion amount for federal and
state estate taxes. The applicable exclusion amount after
allowable expenses is $2 million in 2008 and above $3.5 million
in 2009. It should also be noted that in addition to federal
estate tax, many states impose a state tax on estates with
considerably lower asset levels (often anything over
$1,000,000). Proper estate planning may alleviate this issue.
What about non-spousal beneficiaries? Today,
non-spouse beneficiaries may be able to roll over all or a part
of inherited 401(k) benefits to an inherited IRA. A recent
change in IRS regulations still requires non-spousal heirs to
withdraw a minimum amount from Inherited IRA assets every year,
but it's based on the age of the recipient rather than the age
of the decedent.
Establishing a Stretch IRA. Due to recent changes in
the minimum distribution law, taxpayers may now establish IRAs
designed to stretch out the time period over which a non-spouse
beneficiary (i.e. child) is required to take minimum
distributions from an inherited IRA. Proper use of this vehicle
may potentially allow for continued growth of tax-deferred
earnings over multiple generations and can have a substantial
impact on the future value of the family portfolio.
Naming trusts or charities as beneficiaries. Placing
IRA assets in trust can have substantial advantages but can be
complex. It should only be considered after receiving tax advice
from a competent professional. It is particularly important to
get tax advice related to this issue. Trusts can be complex
instruments with which to bequeath assets, and even though
naming a charity as one's primary beneficiary will not affect
distributions in your lifetime, it could affect the tax
consequences for non-charitable beneficiaries who are sharing
the same asset upon your death.
October 2008 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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