As we have covered before on the blog, the importance of carefully-executed estate planning cannot be understated, and can hold vital importance when transferring your family’s wealth to the next generation – in fact, properly handling your inheritance might be the best way to give your children a leg up in the competitive world we live in. However, there are a lot of factors that go into estate planning depending on the type of bank accounts that you hold, whether you own a family business, and other financial scenarios. One of these is a retirement account.
What is a Retirement Account?
Retirement accounts are investing tools for people looking to save up in preparation for their eventual retirement. Some of the most common assets placed into these accounts include mutual funds, stocks, bonds, real estate and other investments. In the United States, different categories of IRAs (Individual Retirement Accounts) exist to help individuals save for their later days. A traditional IRA is an account into which people can invest pre tax income, and no capital gains or dividend income is taxed until one decides to withdraw from the account. However, there are some restrictions with regard to traditional IRAs. For example, as of 2018, annual individual contributions cannot exceed more than $5,500 in most cases unless you are 50 or older (then you can contribute up to $6,500 a year). In addition, while a traditional IRA is tax-deductible, this only applies to people below a certain level of income (if you make more than $73,000, as of 2018 none of your IRA additions are deductible). While there is no tax break for contributions to a Roth IRA, withdrawals made from these retirement accounts are generally tax-free.
In addition to IRAs, other options exist for a retirement savings account. A lesser known one is an HSA (health savings account) which is a way for people to save money for the future in the case that their health insurance deductibles get unbearingly high. As of now, contributions are capped at $3,350 for a single person and $6,650 for a family (once you are 55 you can add $1,000 per month more). The idea is that you can withdraw money for medical expenses or just use the account to pile up savings, and once you hit 65 years old, you can withdraw the whole balance, though doing so will require a tax payment. There is also the more well-known option of opening up a 401(k) / 40 3(b) by your employer, which is the easiest way for most people to start saving for retirement. One benefit is that you can switch your account to a new employer if you decide to switch jobs. If you decide to start a solo 401(k), you can also roll over an existing 401(k) offered by your employer into your own private account.
The Importance of Naming a Beneficiary…
Perhaps the most important thing to do when it comes to handling your retirement account(s) is to name a beneficiary. If you don’t, your estate will inherit the retirement account as well as a potentially high estate tax liability. Additionally, a court will have to overlook the collection and distribution of the deceased person’s assets to any creditors and designated beneficiaries. Not only will your retirement plan have to go through the expensive and time-consuming probate process, but your inheritance might not get divided in a manner that you agree with or had intended on. Furthermore, if your state does not have a Uniform Probate Code (UPC), which is a set of probate laws, learning the way that probate law works in your local area could be even more of a headache, especially if you are not working with an estate attorney.
Of course, there are other advantages to picking a beneficiary before passing away, one being the luxury of time. If a beneficiary is named, you can withdraw money from your account over the course of your life expectancy. Conversely, if no beneficiary is chosen, the person who is handed the account must take the entire worth of the deceased’s account within five years of their passing. Further, it is in inheritors’ best interests to let the account grow, tax-deferred, particularly since the IRS requires the beneficiary to withdraw a certain amount every year.
Avoiding Mistakes in Choosing your Beneficiary…
The question then becomes: who should be the beneficiary? While the popular answer to this question is your spouse, certain legal nuances exist that may cause you to reconsider. Firstly, it’s important to know that in community property states like Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin and Alaska, your spouse gets to keep half of what you’ve deposited into your retirement account while you are married. This means that your spouse can file a claim to a portion of the assets if other beneficiaries are claimed which often results in the account being sent to probate court. Additionally, all states require that you put your spouse as a beneficiary of your 401(k) unless they sign a waiver.
Fortunately, there are a number of other ways to avoid getting your retirement account into probate. One is to keep your list of beneficiaries up to date after any significant or unanticipated life event (e.g. if your spouse dies before you, change the beneficiary accordingly). Secondly, it is important to work with a financial institution to keep your money managed for a minor until they reach adulthood to avoid probate. Finally, it is recommended that you name alternate beneficiaries, just in case.
Another Option: Make a Trust…
Yes, a good option is to put your retirement account into a trust that can provide ongoing benefits to spouses, children and other beneficiaries and also protect against creditors. This plan of action can be very beneficial as it allows the account to keep growing tax-deferred, for as long as possible. However, the catch with putting IRAs or other retirement accounts into a trust lies in the fact that it must be carefully drafted, specifically because of the way retirement trusts are treated relative to the income tax . If done incorrectly, a familiar problem can arise similar to what happens if beneficiaries are named improperly: the whole account balance will have to be withdrawn within five years of the account holder’s death. Even worse is that the long-term, tax-deferred growth of the funds would incur a sizable and often unexpected income tax payment to the beneficiaries.
Retirement accounts are arguably one of the most important assets that you can put in your estate plan. You’ve worked your entire life to accumulate the assets in our retirement account; it is essential that you engage in proper estate planning so that your hard-earned assets don’t become subject to an unanticipated income tax liability, and more importantly, that they end up in the right hands. If you or a loved one have a retirement account that you would like to leave to your heirs, make sure to consult with a professional estate planning attorney who can guide you through the process of ensuring that your assets are properly dealt with after your passing.