By Kathleen Nemetz, CFP, CDFA
Learn more about Kathleen on NerdWallet’s Ask an Advisor
Naming beneficiaries for IRA and 401(k) accounts is critical: It keeps these assets from becoming part of your estate and potentially raising your heirs’ tax exposure.
But if you don’t plan carefully beyond this move, your heirs could still be haunted by Uncle Sam in the form of big tax bills when they take cash from these accounts.
Many people don’t see this peril because they’re focusing on estate tax exposure. Estates worth less than $5.43 million aren’t subject to federal estate tax, or state estate tax in some states. So people figure that if IRA and 401(k) assets become part of their estate, taxes aren’t a problem as long as the estate’s worth is still below that threshold.
But these folks may not be considering the income tax hit their heirs might take. If you and your heirs don’t take the right precautions, these transfers can result in painful income tax and penalties.
Those inheriting a 401(k) account should look at the plan document or summary plan description to find out what rules apply to their situation. It’s a good idea to ask a tax professional for help, as it can be complicated.
Rules may differ depending on whether the person who died was one’s spouse, and whether he or she was already receiving periodic payments from the account. Some 401(k) plans mandate posthumous lump-sum cash-outs within a defined time period, and such distributions can trigger a tax event.
This is because the money withdrawn from 401(k) plans and IRAs is always taxable. Money goes into these accounts pre-tax and isn’t subject to federal income tax until it’s withdrawn. Remembering this eternally, the ghost of Uncle Sam looks for opportunities to tax these assets as income.
Here’s what you can do to thwart that ghost.
Update your beneficiary information
If you haven’t named beneficiaries for your 401(k) or IRA accounts with the financial institutions that hold them, do so as soon as possible. Otherwise, these assets could become part of your estate and potentially subject to probate fees, state estate tax and, if your estate is large enough, federal estate tax. If you’ve had life changes that affect whom you want to name — such as divorce, the death of a spouse or remarriage — contact the financial institutions holding these accounts and update your beneficiary forms.
Remember that spouses are special heirs
Spouses get preferential tax treatment from the IRS when inheriting retirement-plan assets. (Now that the U.S. Supreme Court has upheld same-sex marriage, these spouses can legally designate their partners as beneficiaries in all 50 states.)
Unlike other heirs, spouses can assume an inherited IRA as their own; they can roll it into their own accounts.
Be aware of advantages for younger spouses
If you die at age 59½ or older, the IRS threshold for avoiding the 10% penalty on withdrawals, your (younger) spouse can avoid this penalty, provided your spouse retains your account as an inherited IRA. But if he or she transfers these assets to his or her own IRA account, this penalty will apply to all withdrawals from that account until your spouse reaches the threshold age.
All withdrawals are subject to income tax — at any age. It’s the penalties that can be avoided. Required distributions will be imposed, and for a spouse’s IRA these apply after he or she reaches 70½.
A spouse who doesn’t need to take withdrawals right away from an inherited account may opt to simply roll over the account to his or her own, to take them later. Even if a spouse makes a decision in favor of an inherited IRA, he or she can later convert the account and roll it over into his or her own.
Pay attention to deadlines
After your death, various moves by heirs regarding these accounts must meet strict IRS deadlines. When transferring assets, heirs need to act within defined windows of time or face disqualification or unnecessary taxes.
Have family discussions
Discuss the transference of retirement accounts with your family now to avoid extra turmoil following your death — for example, unprepared heirs might contact a financial professional who moves assets prematurely in ways that trigger tax hits. Your heirs should get qualified advice in advance and follow up with those same advisors when the time comes. All of this preparation should result in a clear plan listing the necessary steps to take upon your death. Heirs should name their own heirs for the new accounts.
These are just a few considerations for keeping Uncle Sam from haunting posthumous transfers of your tax-deferred accounts. To learn more, contact a qualified financial professional.
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