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. They are setting up and keeping an eye on their Individual Retirement Accounts (IRAs) or Keoghs, or contributing to 401(k) plans (or 403(b) plans, for employees of nonprofit organizations or public schools) under programs set up by their employers. Even after the tumultuous last few years, Americans still had $17.5 trillion socked away for retirement at the end of 2010, according to the Investment Company Institute.

These accounts offer tax breaks now and retirement income later. And even after your death, they can give more benefits for your family because they avoid probate, too. Any money left in one of these accounts at your death goes to the beneficiaries you chose—without going through probate.

When a beneficiary withdraws the money from a 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 Money withdrawn from a Roth IRA, however, generally is not taxed.

The IRS publishes thick books containing nothing but retirement plan rules. These regulations are often next to impossible to figure out, and of course they can change at any time. When it comes to estate planning, focus on the relatively simple task of choosing a beneficiary to inherit the money in your accounts without probate. You'll only have to learn a little about the important IRS rules that govern required withdrawals from the two most common types of retirement plans, IRAs and 401(k) plans.

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.

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