Estate Planning Tips for 401(k)s and IRAs

Many investors have accumulated impressive amounts in their individual retirement account (IRA) and 401(k) accounts. Unlike other assets, both types of accounts pass on to your heirs via a beneficiary designation and not via your will. In addition, there can be both estate and income tax implications with these accounts. Financial advisors can be a great source of advice to clients in planning for the distribution of these accounts to their heirs.

It is important that clients keep their beneficiary designations on these accounts current. In the case of a 401(k) their spouse is automatically the beneficiary unless they sign a waiver to the contrary. These beneficiary designations should be adjusted for changes in your life. If you get married be sure to add your spouse. If you get divorced or become widowed an adjustment will be needed as well. The beneficiary designation is what governs who gets the money. Nothing says “I love you” quite like having your current spouse find out that your ex-spouse is still the beneficiary on your $1 million IRA after your death. (For more, see: How to Handle Client Beneficiary Designations.)

Money held in an IRA or a 401(k) account is subject to federal estate tax. The limits are fairly high. Each person has an exemption of over $5.45 million for 2016. This won’t impact most clients. Individual state estate taxes vary and could have an impact. Additionally, there are no limitations for assets passing directly to a spouse.

Income taxes are a bigger worry than estate taxes for most clients. Traditional IRAs funded with pre-tax dollars and 401(k) accounts funded the in the same fashion at some point will be taxed. In the case of your heirs it will be when they withdraw money from the account. Roth IRAs are not subject to income taxes and neither are Roth 401(k)s. To the extent that there were any after-tax contributions to traditional IRA or 401(k) account that money is not subject to taxes either. There are withdrawal requirements for those who inherit a Roth account. (For more, see: How Advisors Can Protect Inherited IRAs.)

A spousal beneficiary can inherit an IRA and treat as his or her own. Likewise, with a 401(k) or similar retirement plan rolled into their own IRA. They will be subject to income taxes when they make withdrawals. Penalties for withdrawals prior to age 59½ are waived for death, though beneficiaries should consult with their tax and financial advisor here. They will then be subject to required minimum distributions (RMDs) based upon their age. Once they make the inherited IRA their own they will also need to name their own beneficiaries to insure that any money left in the account at their death passes to their intended heirs.

With a 401(k), non-spouse beneficiaries can leave a traditional or Roth 401(k) account with the plan or roll it to an inherited IRA. If you decide to leave the money in the 401(k) be sure to check with the plan provider as to any rules pertaining to the timing of when the money will need to be withdrawn. Some plans will allow beneficiaries to use the account much like a stretch IRA, others may require that the money be withdrawn within five years. If non-spousal heirs decide to roll the money into an inherited IRA, this will work the same way as an IRA from the original account holder being rolled to an inherited IRA account. (For more, see: Tips for Family Wealth Transfers.)

If the original account holder was already taking their RMDs from the account, the non-spouse beneficiary will need to take RMDs as well. However, they will be calculated based upon their age versus that of the original account holder. For younger beneficiaries this can allow them to stretch out the money in the account for a number of years and allow it to stay invested and grow.

While you can’t help your beneficiaries from the grave, some planning and discussion during your lifetime can help them avoid some costly mistakes when inheriting your IRA or 401(k) account. Your financial advisor should also be there to help them through the process after your death and this should be communicated between clients and their advisors. Making these mistakes can result in additional taxes being due and will serve to erode the benefit of inheriting these accounts as intended by the original account holder. (For more, see: Top Tips for Helping Clients Leave an Inheritance.)

Failing to take RMDs: Just as with any IRA or 401(k) account holder non-spouse beneficiaries must take RMDs if they are required. The penalty for any amount not taken is 50% of that amount in addition to the taxes still due.

Failure to properly title the inherited account: Money from an inherited IRA or 401(k) cannot be commingled with the beneficiary’s other IRA accounts. It must be held separately and the account titling must reflect that this is an inherited IRA for the benefit of the beneficiary and from the original account holder. Be sure the custodian chosen understands this and all aspects of an inherited IRA. If the account is meant to be split among several beneficiaries, then an account for each should be established. In addition, the inherited IRA account holder should designate their own beneficiaries to allow for continued stretching of the account in the event of their death.

Failure to divide the account if there are multiple beneficiaries: If there are several beneficiaries and the account remains intact, then the age of the oldest beneficiary will be used when the time comes to take RMDs. If, for example, there are three beneficiaries aged 55, 40 and 25 then the younger beneficiaries will be penalized in terms of having to take larger distributions instead of being able to stretch it out for a longer period of time.  

Passing IRA and 401(k) accounts to their heirs is important to your clients and as their trusted financial advisor you can play a vital role in ensuring that these accounts pass to their heirs in the event of their death as they intended. This is an important part of the overall financial planning work you do for your clients. (For more, see: Advising FAs: Explaining Estate Planning to a Client.)

Many clients have significant sums accumulated in their IRA and 401(k) accounts and wish to pass any unused money in their accounts to their heirs. A knowledgeable financial advisor can ensure that they plan for this properly and can help their heirs avoid costly mistakes in the transfer of these accounts. (For more, see: Estate Planning Tips for Financial Advisors.)