Don’t add the IRS to your list of beneficiaries!
Here are 5 of my favorite tax and estate planning tips for retirement accounts:
- 1. Retirement accounts pass by contract or operation of law, not your will.
- 2. When inheriting an IRA as a spouse, make sure to title it properly pursuant to your goals!
- 3. If the original retirement account owner passed their Required Beginning Date (RBD) and did not take an RMD in the year of their death, the beneficiary(ies) needs to take it!
- 4. If you and your spouse both have large retirement account balances, consider what I call a “spousal skip strategy” for your beneficiary designations.
- 5. Understand the Required Minimum Distribution Rules with Roth 401(k)s vs Roth IRAs
You’ll also learn:
- What your Required Beginning Date or RBD is, and why it is so important
- What is a Required Minimum Distribution or RMD, and how it affects your financial planning
Resources From This Episode:
5 Tax & Estate Planning Tips for Retirement Accounts
Hey everyone. I'm your host, Cameron Valadez, and today, I'm talking about retirement accounts and, more specifically, tips and strategies you should consider if you wanna reduce the tax liability in these types of accounts in order to preserve more of what you worked so hard for all of these years, in order to take care of yourself, your spouse and heirs.
Now, when it comes to your financial assets, it is imperative that you create a plan for your beneficiaries now while you are alive and of competence. If not, your spouse and other beneficiaries may be left with a tax bomb that can't be diffused after you're gone.
If a hefty chunk of your money gets sent to Uncle Sam by mistake, they won't be able to go back and undo your decisions or lack thereof. After all, you want to be in control of what happens with the money you worked so hard to save. Therefore you'll want to decide ultimately how much your family gets when something inevitably happens to you.
In this episode, I'm going to go over retirement accounts specifically and how you can maintain control beyond the grave with my five tax and estate planning tips with retirement accounts.
Tip number one. Retirement accounts passed by contract, or what's called operation of law, not your will. To pass your retirement accounts to your intended beneficiaries, all you have to do is name them as a beneficiary on the account. This makes them a designated beneficiary, and the account can pass directly to them. No will or trust needed. There is also no probate trigger. In fact, even if an IRA or employer plan beneficiary is named or mentioned in a will or trust as a beneficiary, the actual designated beneficiary on the account itself supersedes what the will or trust says.
Naming your intended beneficiaries on a beneficiary form provided by your investment custodian or brokerage is often the most efficient way to pass these retirement assets. The investment custodian is kind of like the company where your account is held. It might be one of the names or logos that you see on your statements that you receive or where you log in online to see your accounts.
Now it is worth noting that for employer plans like 401ks and the like if you are married, federal law says your spouse is automatically the beneficiary. You should, however, still fill out the beneficiary form with your spouse's name anyways, if that is your intention. If you want to name a beneficiary, who is someone other than your spouse, your spouse must sign a waiver to acknowledge that.
This is so important because, in many cases, maybe even your aging parents have retirement accounts, such as IRAs, some with significant balances that make up most of their net worth, and they tend to put their estate plans aside for years, maybe even decades. They get the initial estate planning done, the wills, trusts, beneficiary designations, and the like, and they forget to update them as life goes on.
You might even be guilty of this, too, because as humans, we all tend to get lazy and make mistakes. So then the estate documents and the accounts are only revisited once something happens. But at that time, it becomes incredibly complicated, costly time consuming, or even impossible to fix some otherwise simple mistakes because they are either incapacitated or gone.
In other words, it's too late. Far too often, it's the case that a new client comes to us with a windfall that is not only unexpected but also structured in a way that they know their loved one would not have wanted. And Uncle Sam seems to find his way into these estate plans that are left unattended.
It's worth noting that you do have the option of naming your trust or estate as your beneficiary, even though I don't know why someone would name their estate as their beneficiary, but you can do this rather than naming somebody with a pulse and a birthday. But that's where things get wildly complicated and oftentimes don't work out the way you intended, but we'll save that for another episode.
All right. Tip number two. When inheriting an IRA as a spouse, make sure to title it properly, pursuant to your goals. Too many times, I've seen folks come to us who have inherited a retirement account, such as an IRA, from a spouse and not done their due diligence to determine the best option for them when it comes to taking control of the account.
However, this is understandable since the rules can get complicated and quickly. Now, before we get into this, I want to be sure that you have a basic understanding of what are called required minimum distributions. Now required minimum distributions, or RMD for short, are a minimum amount that must come out of most retirement accounts on an annual basis beginning at what is called your required beginning date, which is actually currently age seventy-two.
Now I know I threw a lot of terms at you there, but just remember, for now, it's age seventy-two, where you have to start taking out a minimum amount from your retirement accounts. I say currently because this is current law and, of course, subject to change in the future.
In fact, prior to just the year 2020, the RMD age was seventy and a half for decades, and there's even a piece of retirement legislation floating around right now that would aim to increase it again to age seventy-five at some point in the near future. Again, this RMD is the minimum amount that you are supposed to take out of your retirement accounts each year. That being said, you can always take more if needed.
The RMD amount is essentially determined by your retirement account ending balances as of December 31st of the year prior. And your life expectancy factor per the IRS's life expectancy tables. There are different life expectancy tables the IRS has, depending on your circumstances, the uniform life expectancy table and the single life expectancy table. The RMD is a moving target and will change each year, depending on those factors.
So what's the big deal about these RMDs? Well, if you do not take at least the required minimum amount out each year, you are assessed a 50% penalty on the amount you should have taken out. This is in addition to the income taxes owed. As you could tell, you don't want to have that happen. The bottom line is that you always want to make sure your RMD is met each and every year once you reach your required beginning date again, which is currently age seventy-two.
Okay, let's get back to tip number two. As a surviving spouse, you have more flexibility compared to other types of non-spouse beneficiaries when it comes to the options for inheriting your deceased spouse's IRA or retirement account.
Think of yourself as the king or queen in the kingdom of beneficiaries. The main advantage of being a spousal beneficiary is that you have the option to treat the inherited IRA as your own IRA or do what is often called a spousal direct rollover or direct transfer to your own existing IRA if you already have one.
In this case, you would not be forced to start taking these pesky RMDs out of the IRA as you would if you left the IRA in your spouse's name and treated it as an inherited IRA for your benefit. This can be very advantageous for spouses due to the tax and investment planning flexibility that's available.
For example, you can have your deceased spouse's IRA titled in your name only if you were the only beneficiary, or you could roll it into your own already existing IRA if you were one of multiple beneficiaries. And therefore, you won't have to take those RMDs until age seventy-two unless, of course, you are already seventy-two.
This means that you won't be forced to recognize taxable income each year if you don't need it. And therefore you can keep the money invested in the account longer. Not only that but if you treat the IRA as your own, your RMDs are based on the IRS's uniform life expectancy table, which gives you a more favorable life expectancy when compared to the single life table, which is used when you choose to leave the account in the deceased name, as an inherited IRA for your benefit.
Now because the uniform life table says you have a longer life expectancy, this means your RMDs each year can be lower and, therefore, can help you manage a lower taxable income over time. Your other option as a spouse, as I just briefly mentioned, is to treat the IRA as an inherited or AKA a beneficiary IRA, just as any other type of beneficiary would have to do. Except as a spouse, you are still able to stretch out the RMDs from the IRA over your lifetime.
As of the year 2020, most other non-spouse beneficiaries do not get to stretch those distributions over their lifetime and are forced to drain the account and pay taxes within just ten years. Now, the recent retirement legislation that began effective in 2020 really ended up hurting those non-spouse beneficiaries simply because the IRS wants their tax dollars sooner. Go figure.
The inherited IRA, in these cases, would be in the deceased name but for your benefit. So this might look something like, “John DOE IRA deceased, June 15th, 2022 F B O or for the benefit of Jane Doe, beneficiary.” Also, it is crucial to make sure that your brokerage or investment custodian changes the social security number on the account to the beneficiaries social security number.
Even if it's being kept as an inherited IRA. Now, this is because any money coming out of the inherited IRA is taxable to you, the new owner. Remember, if you choose to keep the account or treat it as an inherited IRA, your RMD is based on your life expectancy using the single life table and must begin on the latter of two dates. December 31st of the year, the IRA owner that deceased would have reached age seventy-two, or December 31st of the year, following the year of your spouse's death. Remember you can take money out of the inherited IRA at any time, but you aren't required to begin taking at least the annual RMD by whichever of those dates is later.
I won't get into how to calculate the RMD in these cases, as it does get a little complicated and is honestly beyond the scope of this discussion. If you want more help on that, or you have a really unique situation, check out the show notes at the end of the show for more information.
Now, depending on your situation, keeping the inherited IRA in the deceased name could be more beneficial than treating the IRA as your own. An example of this may be a case in which you are younger than your deceased spouse and in need of extra income before you reach age fifty-nine and a half. This technically quote unquote unlocks the ability to take distributions from the IRA without the 10% early withdrawal penalty that would normally apply since that typical retirement account rule doesn't apply to inherited IRAs.
It is also definitely worth noting that as a spouse, you can actually change the inherited IRA to your own IRA later in life if needed. This opens the door for so many more planning opportunities. You can't do this the other way around. For example, you can't treat the IRA as your own immediately. And then, later on, switch it to an inherited IRA because you might need some money out before fifty-nine and a half.
So let's put this together in an example. Let's say you are in your mid to late fifties, and your spouse dies at the young age of sixty. And you, as a spouse, kept the IRA as an inherited IRA in your deceased spouse's name. You can technically delay those RMDs for a little over ten years, in this case, to keep the investments growing for you, tax-deferred. How? Because you don't need to start taking them until December 31st of the year after your spouse would have turned seventy-two.
Remember that was one of those two rules, the latter of. Then at that point, you can decide to change the account to your own IRA once the deceased, whatever reached age seventy-two, and delay the RMDs even further until you reach your required beginning date of seventy-two. Crazy, right? I hope you find this as fascinating as I do.
In this example, if you needed money at any time, including before age fifty-nine and a half, you would have been able to access it and would've never paid a 10% early withdrawal penalty on any of the inherited money. I know this gets a little complicated, but it is so important to understand the nuances of these options or at least have someone help you when it comes to preserving your family's wealth.
Now, please note these rules are for spousal beneficiaries only. The rules get a little more complicated for non-spouse beneficiaries. And again, we will dive more into that in a later episode.
All right, so tip number three. And that is, if the original retirement account owner passed their required beginning date again, currently age seventy-two, and did not take an RMD in the year of their death, the beneficiary or beneficiaries need to take the RMD. This is a rather quick tip but catches so many people by surprise, and oftentimes it honestly gets missed entirely. So I'll repeat it one more time because it is so crucial. If a retirement account owner dies after their required beginning date, then the beneficiary or beneficiaries need to make sure that the current year's RMD gets taken if the deceased had not taken it yet.
For example, if Roger passed away in February of 2022 at age seventy-six, again, he's passed his required beginning date of seventy-two and had not yet taken his full RMD for the year. His beneficiaries have to make sure that the full or the remaining RMD amount is taken by December 31st. Now don't get confused here. This is not the beneficiary's RMD. This is the deceased IRA owner's annual RMD that they were supposed to take but maybe didn't get the chance to, for lack of a better phrase. Therefore it is also based on that individual's RMD calculation rules, not the beneficiary's specific RMD rules.
The beneficiaries don't really have a choice here. Even if the beneficiary wants to delay taking money out for years and let it grow, et cetera, they will still have to take this often unexpected RMD right up front. The biggest nuance here is that the distribution is paid to and taxable to the listed beneficiaries as ordinary taxable income. The distribution is not made to the estate of the deceased if the beneficiaries are listed on the account. Therefore that final RMD, so to speak, is not taxable to the deceased but rather the beneficiary. This is not an issue if the IRA owner passes before their required beginning date because they wouldn't have been subject to RMDs yet. Simple enough. All right.
Tip number four. If you and your spouse both have large retirement account balances, consider what I call a spousal skip strategy for your beneficiary designations. This strategy is specifically for married couples with adult children or other family that they ultimately want to leave their legacy to. It won't really work well for other situations.
Now, this applies to spouses who each have their own large retirement account balances and won't need to depend on each other's retirement assets if one of them were to soon predecease the other. Most spouses, as previously discussed, will name each other as the 100% primary beneficiary of their retirement account. This is very common, very normal.
However, in this strategy, you would instead list your children or other family as the primary beneficiaries and skip your spouse completely. Why would you ever consider this? Well, basically, it's due to the new rules in place post-2020. Like I mentioned before, for those non-spouse beneficiaries, such as children. Now I'm generalizing here, but most non-spouse beneficiaries are now required to drain their entire inherited retirement account balance within ten years of inheriting the account. It's basically one RMD, and they can kind of take it however they want, currently. There is some legislation that may change on that.
Now, this obviously disallows them to stretch those RMDs over a lifetime and therefore forces income taxation sometime within that ten years. Now, if the retirement accounts are big enough, this can lead to a huge destruction of the wealth you've accumulated over a lifetime due to taxes. This is especially true if your children are successful in their own right and are maybe in their peak earning years with high incomes and therefore subject to high tax rates of their own. This doesn't give them much room to plan.
However, there's a better way. If, instead, each spouse lists the non-spouse beneficiaries as the primary beneficiaries, then when each spouse passes away, the beneficiaries will get two separate tenure clocks. If the spouses left each other as the primary beneficiaries, then when one passes, it makes the remaining spouse's IRA much, much bigger, and now there's only one account for the beneficiaries to inherit that has one ten-year clock.
Let me give you an example. If Mom passes away twelve years after Dad, the children got to utilize Dad's IRA as they saw fit for only a max of ten years. Then two years after that, they received the remaining retirement account inheritance when Mom passes and have ten more years to plan on how to use that money.
Now imagine hypothetically that they each had $1 million in their IRAs. If Mom inherits Dad's, she now has $2 million in her IRA, and when she passes, that's $2 million, theoretically, assuming no gain or loss, that will all be taxed at some point within ten years. Now, no matter how you cut that up, that is a lot of forced taxable income to the beneficiary.
If there was one child beneficiary, for example, and they wanted to spread the taxes out as evenly as possible over that ten years, according to the current rules, that's around $200,000 a year in additional income. Think about how much of that is going to go to the IRS because of a lack of planning.
Instead, if Dad passes and the child or children get $1 million taxed over a ten-year timeframe, then another $1 million taxed over a different tenure timeframe, then they can potentially pay much less than taxes since the distributions would be much smaller than in that first scenario. At worst, this provides access to an inheritance earlier in life, spreads out the tax bill, and potentially lowers the aggregate tax bill altogether.
It doesn't stop there either. If in the case that the surviving spouse was the primary beneficiary, he or she would be subject to more taxation when they reached their RMD age. Why? Because surviving spouses actually have to begin to file single for taxes after two years following the year of death. During the two years, they can file married, filing jointly in the year of death, and as a qualified widow.
But after that, they have to start filing singly. And when they file single, they get less preferential tax rates. So in the previous example, if Mom has 2 million at age seventy-two, not only is her RMD going to be bigger because the account is twice as big, but she will have to pay more in taxes regardless because she won't have the more favorable tax rates she had when she was married.
Not only that, but the bigger RMD could subject her to Medicare premium penalties, otherwise known as IRMA surcharge, and nobody likes those. If the other $1 million instead went straight to the kids, she would still have to file single, but her RMD amount would be much, much lower. Remember, in this strategy, for it to make sense, the surviving spouse shouldn't necessarily need the money should the other spouse predecease them.
This is why this strategy can be extremely beneficial. It can really help preserve more of your estate and your net worth. Now I wanna remind you to please use caution when considering a strategy like this, and please consult your estate planning attorney and other professional advisors first.
All right, here it is, our final tip. Tip number five. Understand the required minimum distribution rules with Roth 401ks versus Roth IRAs. This last tip is important because I haven't really discussed the elephant in the room yet, which is the Roth IRA or Roth 401k. While they are still considered retirement accounts, the rules are different, especially when it comes to RMDs.
In general, contributions, or basically the money that you put into the Roth-based accounts, are taxed before the money goes in. Then as long as a couple of simple rules are met, the money you put in and all of its earnings can come out tax-free after age fifty-nine and a half.
Now one caveat to the employer-sponsored Roth accounts, like the Roth 401k, is that currently, these accounts still have the RMD requirements if the money stays in that employer plan and you are no longer employed by that sponsoring company. I say currently because one day this may change. This means that if you leave the company and leave the account, you will be forced to take RMDs out, even though the distributions wouldn't be taxable because it's in a Roth account.
This also means that you are taking money out of virtually the only investment account or vehicle in existence that allows you to compound investment growth tax-free. So as you could probably tell, you don't want to drain these accounts if you don't have to. That's why these RMDs can get really pesky. The RMD rules also still apply if you have an inherited Roth IRA.
So why would there be a required minimum distribution for these Roth accounts since the IRS isn't going to get any more tax dollars necessarily? Why would they force you to start taking money out? All I can say is that hey. It's the tax code we're dealing with here. It doesn't necessarily need to make sense.
However, Roth IRAs owned by you titled in your name, on the other hand, are not subject to RMDs. You can currently leave all of the money in these accounts as long as you'd like. Now, why don't the RMD rules apply to Roth IRAs, but they do to Roth 401ks and inherited Roth IRAs? Again, it's the tax code. So you might be thinking, okay, well then I can transfer the money from my Roth 401k to a Roth IRA and avoid the RMD rules. And you're right. You sure can. And currently, it is really just that simple. Then you can leave the money potentially growing tax-free for decades longer.
An extremely important caveat, however, to know is that Roth accounts have other specific rules that you need to meet in order to having your distributions qualify as being tax-free.
In the case of transferring money from a Roth 401k to a Roth IRA, you'll want to be sure that you meet all of these rules before utilizing a strategy like that. For more information on this, you can grab the link to our blog and the show notes of today's episode, where I dive deeper into some of those rules.
So there you have it. My favorite five tax and estate planning tips for retirement accounts. While there are many more strategies available, hopefully, you were able to get a nugget or two out of today's show to help you reduce your lifetime tax bill and preserve more of your estate for your spouse and heirs.
If you would like to learn more about these rules discussed and want to find even more information to help you retire on your terms, you can find links to the resources I mentioned in this episode's show notes on your podcast app, or you can visit retiredishpodcast.com/one. Again, that's retiredishpodcast.com/1.
Thank you for tuning in and following along. See you next time on Retired-ish.
Speaker 2: Securities and advisory services are offered through LPL Financial, a Registered Investment Advisor, member FINRA, SIPC. The opinions voiced in this podcast are for general information only, and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.