IN THIS CHAPTER

Choosing heirs for your IRA and 401(k)

Meeting deadlines and paying taxes

Leaving company stock

Getting to the five-year mark with Roths

Making donations

Benefiting from a beneficiary IRA

I want to say right up front that passing along money in your retirement account is complex stuff. I only cover the basics here. Please keep in mind that I’m not the one who created the rules; I’m just the one telling you about them.

Get a qualified tax advisor who has experience dealing with these issues to help you. I recommend either an accountant or tax attorney. A fee-for-service financial planner is another option. I don’t recommend a financial advisor who receives compensation from your investments because their opinions can be influenced by the compensation they receive. They also aren’t likely to be knowledgeable enough to provide the help you need.

Deciding Who Gets Your Savings When You’re Gone

When you establish an IRA or join a 401(k), one of the first actions you take is to name beneficiaries to your account. You have to be a little more specific than “my spouse” or “the cousin we call Junior.” Be prepared to provide some details about the people you want to leave your assets to, including

• Name
• Address
• Social Security number

You may be asked to say how your beneficiaries are related to you, whether that’s by blood ties or just friends.

If you want to name a charity as your beneficiary, you need the name, employer identification number, relationship (charity), and address. You also need your spouse’s properly signed consent if the charity is a primary beneficiary.

Naming beneficiaries and keeping them updated assures the benefits will go to those you want to get them. Most 401(k) plans have default beneficiary provisions that apply if none of your named beneficiaries is still living, so your money may go to someone you never intended to have it. Your spouse is the first default beneficiary because this is what the law requires.

IRAs don’t have default beneficiary provisions; therefore, these assets become part of your estate subject to probate if you don’t have a living beneficiary. The benefit recipient will be decided by the court — not you.

Detailing the Distribution

Probate is the legal process of administering an estate. Probate doesn’t apply to assets such as 401(k) and IRA accounts and life insurance when you have one or more living beneficiaries properly filed with the organization responsible for paying out these funds:

• For a 401(k), the employer or the service provider designated by them
• For an IRA, the financial organization that holds the IRA account
• For an insurance policy, the insurance company that issued the policy

Distributions from a 401(k) are made by the financial organization that holds the money. The employer is responsible for notifying the beneficiaries when death occurs; however, the beneficiary will probably have to start the process by informing the employer when the death involves a former employee.

Your employer has an interest in helping a deceased 401(k) participant’s beneficiaries get the money out of the plan, but there is a limit to how much effort the employer will put into tracking down a beneficiary. An employer will be aware of the death of an active employee but isn’t likely to know that a former employee who left the company many years ago and left money sitting in the 401(k) has died. This becomes an even greater problem when businesses are sold, restructured, or otherwise transform because your ties back to the business become much weaker.

The administrative process for other assets is determined by whether you have a will. If you do, probate involves proving that your will is legally valid. After that, the executor you named in your will is responsible for executing your instructions and paying applicable taxes.

Passing without a will leaves your entire estate in the hands of a judge for assets that don’t have a living named beneficiary.

You may also pass assets to a trust when you die rather than directly to individual beneficiaries. A trust is a good idea if you’re leaving money to minor children. You name the trustee who is responsible for managing the assets in the trust. The trustee can be a bank that offers trust services or an individual. The trust you establish also details how the assets may be used and when, if ever, they will be distributed to the beneficiary. Income earned on the trust assets is usually distributed each year to the beneficiary. The trustee can also be given discretion to distribute amounts from the principal to the beneficiary as needed.

The financial organization that holds an IRA won’t know when an account holder dies unless it is informed of this fact.

Include information about your 401(k) and/or IRA accounts with your will and other end-of-life documents and make sure your heirs know where to find them when the time comes.

Talking Timing and Taxes

The Secure Act passed on December 20, 2019, changed the rules for inherited retirement accounts passed on during or after 2020. Now 401(k) and traditional IRA accounts must be fully distributed within ten years after the account holder’s death. That means the recipient of your 401(k) and/or your IRA account must withdraw the entire amount within ten years after your death unless one of the exceptions applies. How much and when to withdraw money during that period is up to the beneficiary: They can take everything out at once or withdraw funds throughout the ten years.

As with all government regulations, there are some exceptions to this ten-year rule: They include a surviving spouse, disabled person, chronically ill person, a child who hasn’t reached the age of majority, and a person not more than ten years younger than you. A surviving spouse may be able to leave the money in the 401(k) and take lifetime distributions.

Your 401(k) plan doesn’t have to give your beneficiaries the option to keep the money in the 401(k). It may require them to take a lump sum distribution, which is fully taxable as ordinary income in the year distributed except for your Roth contributions and the investment gains on them.

The tax liability is a significant issue for a beneficiary who has a high level of taxable income. A beneficiary who already has significant income may be pushed into a higher tax bracket as a result of an IRA distribution.

Your beneficiaries may transfer the taxable portion into an inherited traditional or Roth IRA. With a traditional IRA, the beneficiary avoids paying tax until they take distributions from the inherited IRA. The same rules apply as for any other traditional IRA. For example, in most circumstances, a 10 percent penalty tax applies if money is withdrawn by someone who is younger than 59½. The Roth contributions and investment gains can be transferred into an inherited Roth IRA and continue benefiting from tax-sheltered investment growth.

Any Roth contributions to a 401(k) and investment gains on those contributions shouldn’t be transferred into an IRA because no taxes are owed.

Converting the taxable portion of the distribution into a Roth IRA means paying taxes during the year of the conversion. The taxable portion includes your pre-tax contributions, employer contributions, and investment gains on these contributions. The beneficiary may use part of the distribution to pay the applicable taxes, which results in less money going into the inherited Roth IRA. The beneficiary can use other sources to pay the taxes and can then transfer the entire taxable distribution into the inherited Roth IRA.

The beneficiary receiving the 401(k) distribution then names beneficiaries for either type of inherited IRA.

Distribution options within a 401(k) are possible only if the plan permits them. For example, the plan may require a mandatory lump-sum distribution to the beneficiaries. I advise my 401(k) clients to permit only lump-sum distributions because participants and beneficiaries have similar options via an IRA rollover as they do if the money is left in the 401(k). They are able to defer having to pay taxes by rolling the money into an inherited IRA.

Passing along Company Stock

The applicable laws are complex when it comes to employer stock held in your 401(k) account. The value of the stock when you received it in your 401(k), the cost basis, is taxable to you as additional income during the year the stock is distributed. The plan’s administrator is required to provide the value of the stock when it was contributed. Your beneficiaries can get a huge tax break if you retain the stock and have it pass to your beneficiaries.

Imagine you have a retirement account with $100,000 of employer stock and the cost base is $40,000. You have to pay income tax on the $40,000 cost base if you roll over the stock into a brokerage account instead of an IRA. This way you avoid paying income tax on the $60,000 increase in value that has occurred over the years. You can avoid paying any tax on the gains until shares of the stock are sold. When you sell any shares of the stock, the gains will be taxed at the capital gains tax rate rather than at your income tax rate. This gives you a tax break as long as capital gains tax rates are less than income tax rates. You lose this advantage if you transfer the stock into an IRA.

You can sell portions or all of the stock anytime you want after the transfer into the brokerage account. Say you sell $10,000 worth of the stock shortly after the stock is transferred into the brokerage account when the total value of the stock is still $100,000. This means you will be selling 10 percent of the shares. The cost base for those shares is $4,000 (10 percent of $40,000). You won’t owe any tax on this portion because you already paid tax when the stock was transferred into the brokerage account. The increase in value taxable as a capital gain is $6,000 (10 percent of the increase in value). You have to pay capital gains tax on the $6,000 gain.

The risk of having a large amount invested in only one stock during your retirement years needs to be considered before you decide to go this route. You can sell all or some of the stock after you retire at any time to reduce this risk. You can, for example, pay tax on the $40,000 value, transfer all shares into a brokerage account, and decide to sell 5 percent or some other percent each year. Normally you must hold stock for one year to have the gain taxed as a capital gain. The one-year requirement doesn’t apply in this instance.

Passing as much of the stock as possible to your heirs provides them an additional major tax advantage. Your beneficiaries get the stock at a stepped-up value for tax purposes. Using the $100,000 example, they don’t have to pay any tax on the $60,000 increase in value of the stock. They also don’t have to pay any tax on any additional increase in value during the time the shares were transferred out of your 401(k) account into your brokerage account.

They pay capital gains tax only on any increase in value of the shares after they receive them and only when they sell the shares. If the stock is worth $200,000 when you die and if your heirs promptly sell the shares at the same value, they don’t have to pay any tax. That means no taxes are ever paid on the $160,000 increase in value of the stock that occurred after the shares were contributed into your 401(k) account.

Reducing your investment risk can backfire on your heirs. Say you transfer company shares into an IRA and then sell the shares to reduce your investment risk by investing the money in a diversified portfolio. The entire value of your portfolio is taxable to your beneficiaries as additional income at their personal tax rates. The amount of tax they must pay can be substantial, particularly if they have lots of earned income. You reduced your investment risk by selling the stock and investing in other things, but your beneficiaries must pay a lot of taxes.

The situation is different if you need to convert your entire 401(k) account into a stream of income that will last the rest of your life. Selling all or a large portion of the stock so you can properly diversify your investments may be the best decision.

Starting the Roth Clock

A Roth IRA offers estate-planning opportunities because the entire account can be retained until death without any required minimum distributions. The account can grow without any tax on the investment gains during the account holder’s enter lifetime. If your contributions to a 401(k) plan are made to a Roth account, the required minimum distribution rules still apply, and you will be required to withdraw part of your account each year.

The five-year Roth IRA requirement is a great reason to establish a Roth IRA soon if you have significant 401(k) and/or IRA accumulations. A Roth IRA must be in existence for at least five years before you can avoid paying taxes on the investment gains you withdraw. Even if you put just $1,000 into it, you start the five-year clock ticking, which will make your beneficiaries thankful.

Having living beneficiaries for your 401(k) and IRA at the time of your death enables these funds to go to these individuals promptly after your death. Otherwise, these funds have to go through probate, which will delay the transfer and result in unnecessary fees.

Qualifying Your Charitable Giving

Another estate-planning issue worth considering if you’re approaching retirement or have already retired and successfully accumulated a lot more in a tax-deferred 401(k) or a traditional IRA than you need for your retirement is a qualified charitable distribution, or QCD.

Being a Beneficiary

If you’re a beneficiary of someone else’s retirement plan, you have to do a little bit of work and maybe some contemplation about how to handle your windfall.

Before you get access to the funds, you most likely have to fill out a form that asks for some or all of the following information:

• The name of the decedent (the person who died and left you the account)
• The decedent’s Social Security number
• The decedent’s account number
• Your name and contact information
• Your Social Security number and date of birth
• The account number the funds are going into

Keep this information handy; you’ll need most of it when you open your beneficiary IRA.

Opening an inherited IRA means you need to name your own beneficiaries. See the “Deciding Who Gets Your Savings When You’re Gone” section earlier in this chapter for the information you need for that form.