Like many Americans, you may have money in your 401(k) or IRA plan. For most people, contributing to an IRA is wise, especially if your employer matches all or part of your contribution. After all, qualified plans and Social Security benefits form the foundation of most retirement strategies.
You may even have thought about how to pass that money to your loved ones when you die. You want to ensure that your loved ones are taken care of and that the IRS gets the least amount of your legacy.
Leaving the money in your qualified plans to your beneficiaries is not the only way to create a legacy. In fact, leaving IRA and 401(k) money to their heirs may have costly tax implications.
Could leaving behind an IRA destroy your legacy?
Leaving 401(k) or IRA money to children, grandchildren, or other beneficiaries can expose them to unintended tax issues. In some cases, beneficiaries could lose 40-50% of their inherited money.
In the past, many financial advisors addressed this potential tax consequence by helping clients create a “stretch IRA.” Stretch IRAs allowed people to draw out traditional IRAs’ life and tax advantages. In addition, stretching out an IRA allowed the funds in it to have longer to grow tax-deferred.
The passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act by President Trump at the end of 2019 ended the ability to use stretch IRA planning.
As of January 2020, SECURE required beneficiaries to take out all the money in inherited 401(k) plans and IRAs within ten years. This provision has an even more substantial impact when a person inherits an IRA through a trust. This is because the money in a trust is generally inaccessible. As a result, a beneficiary of an IRA must take the entire amount of the inheritance as a lump sum, and cannot receive distributions over time.
The lump-sum payout is taxed as regular income at the beneficiary’s income tax bracket. Since most payouts begin while a beneficiary is still working (and is thus in a higher tax bracket), payouts could trigger an unwelcome, perhaps substantial, tax bill.
Life Insurance or Annuities May Help
Specially modified whole life insurance policies offer tax advantages and are a good alternative to passing on your 401(k) or IRA. They provide liquidity, money control, and other “living benefits.” Generally, proceeds from a life insurance policy are not included in your gross income at tax time. However, not every licensed insurance agent knows how to design these policies properly, so seek advice from someone with experience.
Annuities are another tax-advantaged method of creating a legacy from your qualified plan savings. However, only certain kinds of annuity products fill this need adequately. It is possible to roll over a 401k account into an annuity, but it must be done correctly to avoid losing tax advantages. Annuities are somewhat complicated and come in multiple configurations. Therefore, you must seek assistance from an annuity specialist.
The bottom line:
Rolling over a 401k or IRA is a minefield of rules, regulations, and timelines that could cause you to make costly mistakes. Therefore, it’s best to make a plan well before retirement. Also, be sure you understand each decision’s implications, especially the potential impact on your beneficiaries.