Estate Planning: IRAs and 401(k) Accounts

Retirement plans can be a significant part of your estate plan.

Millions of employees and small business owners are now in charge of their own retirement plans. Even after the tumultuous last few years, Americans still had $32 trillion socked away for retirement at the end of 2020, according to the Investment Company Institute.

Here's a brief overview of how common retirement plans work—how they can offer tax breaks now and retirement income later—as well as considerations to take into account when estate planning.

The Tax Advantages of Retirement Plans

Traditional IRAs and 401(k) Plans. First, the money you deposit each year (up to the legal limit, which depends on the type of retirement plan) is tax-deductible. That means at income tax time, you can reduce your taxable income by the amount of your contribution.

Second, the income and profits that come from investing the money you save generally aren't taxed now, either. All of it can be reinvested and start earning income itself.

Of course, nothing good lasts forever. Eventually, you must start making withdrawals, and when you do, the money you take out will be subject to income tax (unless some of your contributions were not tax-deductible). By then, however, presumably you'll be retired and in a lower tax bracket. (Internal Rev. Code § § 72, 219.)

Roth IRAs. The Roth IRA is a whole different animal. Contributions are not tax-deductible. Income accumulates tax-free, however, as long as the contributions stay in the account at least five years. Most important, qualified withdrawals are not taxed. There are no mandatory lifetime withdrawals.

Estate Planning Considerations for Retirement Accounts

Avoiding Probate on IRAs, 401(k) Accounts, and Pension Plans

Probate is the court-supervised process of transferring your property to your heirs. It's beneficial to avoid the probate process whenever you can, since it costs your heirs time and money. Fortunately, any money left in an IRA, 401(k), or pension at your death can easily bypass the probate process; you simply need to name a beneficiary or beneficiaries on these retirement accounts, and they will pass directly to the people you've named without the need for probate.

How Withdrawals From Inherited Retirement Accounts Are Taxed

When a beneficiary withdraws the money from your 401(k) plan or traditional IRA after your death, the tax deferral ends; the money is treated as taxable income of the beneficiary. This is unlike other inherited assets, which are not subject to income tax. Money withdrawn from a Roth IRA, however, generally is not taxed. (Remember that unlike traditional IRAs and 401(k)s, Roth IRAs contributions were already taxed.)

Withdrawal Deadlines for Beneficiaries Who Inherit Retirement Accounts

The IRS publishes thick books containing nothing but retirement plan rules. These regulations can be quite complicated, and of course they can change at any time. For an overview of how the SECURE Act—which became effective in 2020—has changed the playing field, see How the SECURE Act Affects Your Retirement and Estate Plans. For example, the SECURE Act has imposed a ten-year rule on many beneficiaries: They have ten years in which to deplete the inherited retirement account.

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