Posted by Ronald J. FicheraJul 16, 2022
Be careful who inherits your IRA, and be smart about how they are allowed to do it. It could save them a potentially 40% tax hit.
People often don't make the time to check their beneficiaries, but if you own any retirement savings accounts, such as an Individual Retirement Account (IRA), 401(k) or other accounts that offer tax-deferred growth, you may be surprised at who might benefit from your account in the event of your passing.
IRAs appeared for the first time on the financial scene in 1974. These accounts were never intended to be assets you could pass on to beneficiaries, but only to encourage retirees to have a secondary source of steady income to supplement their Social Security benefits and employer pensions. For this reason, Required Minimum Distributions (RMDs) were enacted for account owners once they turned 70½, so that they would ideally deplete their resources throughout retirement (and eventually pay taxes on the tax-deferred earnings).
Without proper planning, your IRA could easily become a tax nightmare. However, you can avoid this tax trap by properly planning your beneficiaries, picking the right retirement account type, and making sure to find the proper adviser to help with the process.
Beginning in 2002, a few significant changes occurred for IRAs and the policies that govern their distributions. Life expectancy tables were updated to reflect longer life spans, more options if the account owner's spouse was more than 10 years younger, and the Separate Account Rule was implemented. Essentially, this rule allows account owners to choose how their beneficiaries would receive the remaining funds in their retirement — either in a lump sum (the previous mandatory policy) or allowing the funds to continue earning tax-deferred benefits.
If IRA owners want their beneficiaries to continue enjoying the benefits of tax-deferred earnings, they need to make the right beneficiary choices. Referred to as the “Stretch IRA” or “Multi-Generational IRA,” this will alleviate beneficiaries from immediate taxation on a lump sum or five-year distribution, which can be up to a 40% or more immediate loss of the account balance.
The “Stretch IRA” concept
A Stretch IRA can save your beneficiaries (and potentially, if planned properly, their beneficiaries) thousands of dollars in unforeseen taxes. A Restricted Beneficiary Form can designate the creation of a separate account for each beneficiary in their name. However, your beneficiaries will need to begin their RMDs starting the year after your death, not by age 70½ (the age you would typically start distributing RMDs). They must pay taxes on only the amount withdrawn every year from the retirement accounts, taxed as ordinary income.
The process of picking and keeping your beneficiary wishes up-to-date may be a complicated one, but the right financial adviser will help ensure that all the proper steps are in order. Don't make the mistake of assuming that your survivors will fulfill your intended wishes. Also, another costly mistake is assuming that your will handles retirement account beneficiary designations. For that reason, beneficiary forms always surpass instructions found in your will—thus making them crucial documents to have in your possession.
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This article was provided by Carlos Dias, Jr., a financial adviser, public speaker, and president of Dias Wealth, LLC, and brought to you by the Ronald J. Fichera Law Firm, where our mission is to provide trusted, professional legal services and strategic advice to assist our clients in their personal and business matters. Our firm is committed to delivering efficient and cost-effective legal services focusing on communication, responsiveness, and attention to detail. For more information about our services, contact us today!
This article was written by and presents the views of our contributing adviser. This is not tax advice and should not be construed as such. Please seek professional tax services for more information and advice that will apply to your specific tax situation.