For many middle-class families, the biggest or second biggest asset they have is their retirement account. Unfortunately, our wonderful politicians and IRS have made retirement accounts into a mine-field of taxes. Without proper care, taxes can completely wipe out a retirement account for you and your beneficiaries.
As an estate planner, not a financial advisor, ensuring retirement accounts are properly handled is at the top of my to-do list with each and every client. The difference can be worth, quite literally, millions and millions of dollars. More family fortunes are lost through improper retirement account handling than anything else. Even if this sounds complicated, I urge everyone to re-read the material until you understand it. The difference can mean hundreds of thousands of dollars, if not millions.
One of the most important steps in protecting your retirement account is to roll a company retirement plan account (like a 401(k) into an IRA account. However, the work doesn’t stop there. Before the company plan is ever rolled over, you should always, and I mean ALWAYS… name designated beneficiaries.
Why? I’ll answer that in a second, but first lets make sure we’re all on the same page with the vocabulary (the “financial speak") of retirement accounts and accounting.
First, what is an IRA? An IRA stands for “Individual Retirement Account". An IRA is permitted by law and if you are under 50, you can start and contribute a maximum of $4,000 to a traditional IRA. If you turn 50 during the year or are over 50, you can add another $1,000 which is called a "catch-up" contribution. If you turn 70 ½ during the year, you can't make any contribution.
The benefit of an IRA is that, like a company retirement plan, you can contribute money without income tax, and the money can then grow tax free. The initial contributed amount is then taxed when you withdraw the money in later years. The interest earned is obtained tax free and absent falling into an IRS trap, can lead to substantial wealth. Withdraws are also heavily regulated (a discussion for another article) with many more pitfalls.
You are also permitted to “roll over" a company plan into an IRA. This means you withdraw all the money from your company retirement account and place the money into an IRA account. There are numerous pitfalls in doing so, and I will deal discuss those pitfalls in a subsequent article.
A major benefit of an IRA is that a designated beneficiary does not have to take the full amount in an IRA out after your death, and can “stretch" the distributions over his/her lifetime.
So what is a “beneficiary", and what is a “designated beneficiary"? A beneficiary is anyone who might receive a portion of your property after you pass away. A designated beneficiary is someone who is specifically named and documented by you, who will have a contractual right to designated property upon death. Almost any property that has a title can have a designated beneficiary; bank accounts, houses, cars, and retirement accounts. The property passes outside of probate, and in the case of IRAs, the designated beneficiary obtains other benefits.
The primary benefit, as noted above, is the ability to stretch. By law, all company plans must be cashed out within 5 years by the beneficiaries of your estate. Regular beneficiaries of an IRA must cash out within 5 years as well.
If you don’t understand the “tax speak" that follows, trust me for now, the difference in taxes is very substantial for most retirement accounts.
Having to cash out all at once equates to substantial tax losses. First, your heirs will have to pay the entire tax on the IRA at the time they cash out. Since taxes are tiered, your heirs will have to pay the highest marginal tax rate on an amount over around $75,000 (the top tier can change depending on what politicians do with the tax code). Most IRAs will have substantially more than $75,000, and so a major portion of most IRAs will be taxed at around 35% or more depending on the tax code in that year.
In addition, once cashed out, the money in the account can no longer continues to earn investment interest.
By “stretching", a designated beneficiary can take a minimum amount out of the account each year. The majority of the money taken out is taxed at a lower tax brackets (since most minimum distributions will be below the highest tax bracket), and leads to saving lots of money.
In addition, much of the account will remain inside the account, and continue to earn interest for the entire life of your beneficiary. Since most distributions are below 5% of the total account, any year in which your account earns 5.1% or more will continue to add value and money to the account.
A final benefit; IRAs have a minimum age at which point a IRA owner MUST begin taking minimum distributions from their plan, in the year after you turn 591/2. Why do politicians add an extra ½ a year to the distribution rules? To help ensure more middle-Americans fall into yet another trap.
Any money taken out of your IRA before you turn 591/2 is taxed with an additional 10% penalty. If you die before you even get to 591/2, any amount taken out by a regular beneficiary is taxed with a 10% penalty. A designated beneficiar y has no requirement to take any amount out until you would have turned 591/2. Thus no 10% penalty and your line retains even more of the money you worked hard to earn.
The process of naming designated beneficiaries, including back-up beneficiaries, is particular, and should never be done without the advice and guidance of a financial advisor who is trained in IRAs. Fewer than 1% of financial advisors are trained as IRA experts, so make sure you ask questions and protect your fortune.
So make SURE your retirement accounts have a designated beneficiary named, and continue to update these beneficiaries periodically.