Baby Boomers are retiring every day and Generation X is right on their heels. With this, an increasingly large amount of wealth is making its way into IRAs and Roth IRAs. It has been my experience that individuals don’t quite grasp the complexities of such accounts. On the surface, they seem pretty simple. Contribute to an IRA or Roth IRA, receive tax-deferred growth, and withdraw the funds during retirement. Anything that’s left over after you pass away goes to the listed beneficiary.
If only it were so easy to accomplish your goals. As your wealth in these accounts grows over time, you will feel an increasing sense of responsibility to make sure your family is taken care of when you pass away.
You want to review how your assets will be distributed at your death, to make sure the distribution lines up with your wishes. Different accounts and assets receive different tax treatment at your death, which requires additional monitoring.
Here are my best practices for handling your IRA or Roth IRA with respect to your estate plan:
Check your beneficiaries. The beneficiary designation on your retirement account was likely decided on when the account was opened, if at all. Review your beneficiary designation online or call your financial institution and ask how it is listed. The beneficiary on your IRA or Roth IRA takes precedence over your will or trust. An up-to-date beneficiary listing is a requirement to pass on your account as you wish.
Consider your tax situation. Review your overall estate plan and see where your assets are destined to go. The most likely recipients? Your family, Uncle Sam, and charity. That last one is important. If you are planning to give to charity at your death, it should be with Taxable IRA dollars. Why this strategy? Charities don’t pay taxes, but your family does. Leave tax-free assets to your heirs, like life insurance proceeds and Roth IRA dollars. This strategy will maximize the after-tax value of your estate.
Let your beneficiaries stretch. When your heirs inherit a Taxable IRA, they will want to let it receive tax-deferred growth for as long as possible. Cashing out the account entirely within a few years will result in a higher tax bill than necessary, by bumping up to a higher tax bracket. If your heirs want to utilize a stretch IRA, you must list a “designated beneficiary.” This means it must be a living person or a qualifying trust on the beneficiary form. With the stretch IRA, your beneficiaries can take required minimum distributions (RMDs) over their life expectancy. For example, a forty-year-old beneficiary could stretch out distributions for 43.6 years, using the IRS Single Life Expectancy Table.
Help your beneficiary’s tax situation. With lower levels of earned income, it is likely that a retiree is in a lower tax bracket than their employed beneficiaries. By converting a pre-tax IRA into a Roth IRA, you can potentially pay tax at a lower rate than your heirs will. If your IRA is sizable, you will want to partially convert the account over many years, instead of all at one. Not only does this keep you in a lower tax bracket, but will also help keep your Medicare premiums low.