Inheriting an IRA or 401K - If You Aren't a Spouse
A tremendous number of Americans have money in an IRA. Many more are sinking huge portions of their salaries into a 401(k) accounts. With an increasing number of employers also contributing matching funds, it is no wonder that the fastest growing, largest pot of money in our society today sits in some sort of retirement plan.
Many never think about what happens when family members inherit these accounts and The Tax Man wants his piece of the action.
A ticking time bomb.
IRA's and 401(k)'s are not inherently bad investments. Quite to the contrary! Most of them trigger a tax break when money is added. At the very least, no tax is owed on earnings until the money is ultimately touched. There is an increasing trend to retire and either live off the earnings of these accounts or never touch them at all. Even the mandatory withdrawals at age 70 ½ don't deplete the account for a long time. This leaves a lot of money to beneficiaries that has never been taxed. Leaving money to your spouse as beneficiary doesn't trigger any taxes if no withdrawals are made. But once the funds finally make it to the children, that's when things get interesting. Too many times, the children just cash out the whole account minus the tax. On average, this leaves only 50-80% of the balance in their hands.
Beneficiaries other than a spouse can cash out and pay a ton of tax OR take payments which allow most of the money to continue to grow. This cushions the tax blow. Payments are made from an account called a Beneficiary IRA and can be paid out - for as short as 5 years or as long as a lifetime. For more money in the long run, the Beneficiary IRA is the only way to go.
Let's look at an example.
Out of a $500,000 IRA, if a son decided to cash out, he would walk away with about $300,000 after tax. Instead, if the son were age 50 and set up a Beneficiary IRA, he would start off taking an income of around $16,000 per year AND have close to $750,000 at his age 65 if the investment grew at 6%.
Rules get even more tricky if no beneficiary is listed or if "estate" is listed on the beneficiary form. Also, if the beneficiary is a non-living person (like a charity or trust), then other rules apply.
It is best to consult a qualified financial planner on the subject, especially if your beneficiary has designated multiple children or a charity. You could end up limiting the growth of your 401(k) or IRA when it passes to your heirs just by not knowing your options or dying at the wrong time!
Many never think about what happens when family members inherit these accounts and The Tax Man wants his piece of the action.
A ticking time bomb.
IRA's and 401(k)'s are not inherently bad investments. Quite to the contrary! Most of them trigger a tax break when money is added. At the very least, no tax is owed on earnings until the money is ultimately touched. There is an increasing trend to retire and either live off the earnings of these accounts or never touch them at all. Even the mandatory withdrawals at age 70 ½ don't deplete the account for a long time. This leaves a lot of money to beneficiaries that has never been taxed. Leaving money to your spouse as beneficiary doesn't trigger any taxes if no withdrawals are made. But once the funds finally make it to the children, that's when things get interesting. Too many times, the children just cash out the whole account minus the tax. On average, this leaves only 50-80% of the balance in their hands.
Beneficiaries other than a spouse can cash out and pay a ton of tax OR take payments which allow most of the money to continue to grow. This cushions the tax blow. Payments are made from an account called a Beneficiary IRA and can be paid out - for as short as 5 years or as long as a lifetime. For more money in the long run, the Beneficiary IRA is the only way to go.
Let's look at an example.
Out of a $500,000 IRA, if a son decided to cash out, he would walk away with about $300,000 after tax. Instead, if the son were age 50 and set up a Beneficiary IRA, he would start off taking an income of around $16,000 per year AND have close to $750,000 at his age 65 if the investment grew at 6%.
Rules get even more tricky if no beneficiary is listed or if "estate" is listed on the beneficiary form. Also, if the beneficiary is a non-living person (like a charity or trust), then other rules apply.
It is best to consult a qualified financial planner on the subject, especially if your beneficiary has designated multiple children or a charity. You could end up limiting the growth of your 401(k) or IRA when it passes to your heirs just by not knowing your options or dying at the wrong time!
posted by Shari Burnum @ 11:22 AM
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