Funds that remain in a retirement account when you die are considered part of your estate, and they can be transferred to beneficiaries without going through probate. However, the use of retirement plans as an estate planning tool is limited. Once you reach age 70½, you generally need to withdraw a certain amount from a retirement account each year to avoid penalties. This is because the account is meant to benefit you rather than your heirs. As a result, you may not have much money left in a retirement account if you live a long life.
Traditional and Roth IRAs
You can start a regular individual retirement account (IRA) by making contributions. They are tax deductible up to a certain amount ($5,500 as of 2018), and people who are 50 or older can make additional annual contributions that are also tax deductible. You can control how the money in these accounts is invested, and you do not pay tax on the money that the accounts earn, although you do pay tax on the money as income when you withdraw it from the account. IRAs for small businesses and people who run their own businesses are known as SEP-IRAs. These have higher contribution limits that are determined according to the individual’s net income.
The main advantage of a Roth IRA is that you do not need to start withdrawing money from it each year once you reach a certain age. You can choose to leave all of the money in your Roth IRA for children or other beneficiaries. Money that goes into a Roth IRA already has been taxed, and earnings from the account are tax-free. If the funds remained in the account for five years, you do not need to pay income tax when you withdraw them.
You can name multiple beneficiaries of a traditional or Roth IRA, and you can determine how to allocate the contents of the account among them. Furthermore, you can name alternate beneficiaries for each primary beneficiary. Alternate beneficiaries can receive the primary beneficiary’s share if the primary beneficiary dies or is otherwise unable to receive it. (You should be aware that, if you live in a community property state, your spouse will have an interest in half of the money that you have earned during your marriage unless they sign a waiver of this right.)
Employers may provide an option for employees to pay some of their pre-tax income into these plans. The employer then may make contributions to the account as well, and the total is invested. The rules for withdrawing from the account based on your age are the same as with traditional IRAs. Any leftover funds when you die go to a single named beneficiary, who generally must be a surviving spouse if they exist. Non-profits can offer similar plans, known as 403(b) plans.
Any funds remaining in these plans when the employee dies can be rolled over into an IRA of a beneficiary. This means that the beneficiary’s life expectancy determines the amount of withdrawals in any given year. As a result, the beneficiary may be able to reduce their income taxes by spreading out withdrawals over a long period rather than receiving the contents of the deceased person’s IRA in a single chunk.
Employers do not need to offer a pension plan or pay benefits to any beneficiary named by the employee. The business controls the pension plan, rather than the employee, and the employee does not actually own the assets in the plan. In some situations, the employee’s spouse may have the right to receive benefits from the pension plan after the employee dies, but this is not guaranteed. You also may or may not be able to designate beneficiaries to receive benefits from your pension plan, since the employer sets the plan’s requirements.
Tax Impact Upon Death
While money in retirement plans technically is subject to federal estate tax when you die, tax may not need to be paid unless the value of your estate is huge. However, beneficiaries must pay income tax on money left in retirement plans other than Roth IRAs when the plan holder dies. (There may be some exceptions for surviving spouses who have their own IRAs and can transfer the money from the deceased spouse’s IRA to their own IRA.) Since money in a Roth IRA was already taxed, it does not need to be taxed again when the beneficiary inherits it, although account earnings after that point can be taxed.