Estate Planning for Persons with Large Retirement Accounts

When it comes to planning for the future, both retirement planning and estate planning are equally important. While the former will ensure that you have enough money to last your non-working years, the latter will ensure that your money goes to its rightful inheritors. Retirement accounts like an Individual Retirement Account (IRA), a 401(k) retirement account, Roth IRA, Roth 401(k), etc., are common choices for most people. These accounts can offer tax benefits along with decent growth on your money. They have some strict rules, and you must adhere to the contribution limits, withdrawals limits, and other criteria to avoid penalties. But all in all, they are quite handy for risk-free savings.

Your retirement accounts are like your lifelines in retirement. They keep you financially secure and independent when you are old and unable to work to earn a living. Therefore, it is important to understand how each of these retirement accounts work before you invest, so you can fully benefit from them, a task a professional financial advisor can help you with. Your retirement account savings can also help your spouse, children, or grandchildren in the form of inheritance, especially if you have a large retirement fund. Hence, understanding the effects of 401k inheritance tax or IRA estate tax is equally necessary.

This article talks about everything there is to know about retirement accounts and estate planning. Read on to know more.

Are retirement accounts taxed after death?

Yes, retirement accounts are taxed after death when passed on to your legal heirs. There are different taxes that the Internal Revenue Services (IRS) may levy on your accounts. The burden of paying these taxes falls on the shoulders of the inheritor, such as a spouse, child, or grandchild. Taxes are levied on retirement accounts as well as on any other assets, such as real estate, mutual funds, stocks, bonds, life insurance plans, etc. that you may have inherited. Here are some taxes that may be levied on your assets:

Income tax:

Retirement accounts are subject to state and federal income tax. However, in the unfortunate event of death, before your heirs inherit any of your assets, they will go through a step-up basis. As per this, the capital gains earned on your assets from the day they were purchased to the day they were inherited are removed, thereby reducing the tax liability of the inheritor. But if you own a large retirement fund, the taxes charged could still be high even after removing the capital gains.

It is important to understand how your retirement accounts are taxed when your heirs withdraw money from them. All retirement accounts except Roth IRAs can be taxed after the death of the primary account owner. Roth IRAs cannot be taxed on withdrawal by your heirs as you have already paid tax on your contributions. However, in the case of a traditional 401(k) or IRA, when your heirs make a withdrawal, the money is no longer treated as tax deferred funds. Therefore, the withdrawals are added to the heir’s taxable income and taxed as per the tax slab they fall into.

Estate tax:

There are two types of estate taxes that are levied – one at the state level and the other at the federal level. When your heirs inherit your assets, they have to pay taxes on them, depending on the value of your asset. As of 2021, for an individual, assets up to $11.7 million can be passed on to their heirs without incurring any federal tax. For married couples, assets up to $23.4 million can be passed on to the heirs without attracting any federal estate tax. While these figures may seem high and may not impact most retirees, they can have severe repercussions on people with a large estate and high retirement account savings.

State taxes, on the other hand, can differ for each state. Not all states levy a state tax, so you should check the rules of your state before you decide to settle there after retirement. The state you pick can significantly alter your estate. For instance, Hawaii and Washington have the highest estate tax of 20%. These taxes are paid from the estate and then passed on to your heirs. So, the higher the tax, the lower is the amount inherited.

GST tax:

A lot of people leave their retirement accounts for their grandchildren instead of their children. While leaving your estate behind for your grandchildren can help them in several ways, it can also result in a huge tax liability because of the Generation Skipping Transfer tax. The GST tax is a federal tax that is levied in case of an inheritance transfer if the inheritor is at least 37.5 years younger than the original owner. This happens when you skip a generation and pass on your assets to your grandchildren directly instead of your children. This tax was introduced in 1976. Before the tax was established, people could transfer their assets to their grandchildren without incurring any tax liabilities. However, with the introduction of the tax, you now have to pay a flat GST tax of 40% when passing on your estate to your grandchildren. GST may result in the same tax liabilities for your grandchildren as inheritance tax for your children. As of 2021, the GST tax exemption limit is the same as the federal estate tax limit of $11.7 million for an individual and $23.4 million for a married couple.

Some important things to know about RMDs of large retirement accounts after inheritance

RMDs or required minimum distributions are mandatory withdrawals that an account owner or inheritor has to make after a certain age. Earlier, non-spousal and spousal inheritors could choose not to make distributions and let the money grow tax deferred in the retirement accounts. However, the Setting Every Community Up for Retirement Enhancement (SECURE) Act removed this provision for non-spousal beneficiaries. Starting from 2020, all non-spousal beneficiaries like children, grandchildren, etc., have to take RMDs. According to the new Act, beneficiaries other than the spouse need to withdraw the entire value of the retirement account within 10 years of inheriting the account. If the retirement account still holds any money after the 10 year period is over, the IRS will levy a 50% penalty tax on the account.

401(k) and IRA estate tax planning are very important, especially if you want to pass on your retirement accounts to your children. As a non-spousal inheritor, your heirs can severely lose out on money due to heavy taxes. For instance, if your child inherits an IRA with a value of $1,000,000, they would have to withdraw this entire amount in 10 years. This can amount to a taxable income of $100,000 every year from the retirement account alone. Coupled with your child’s annual income, this could place them in a high tax bracket.

Useful ways to reduce the costs incurred by your inheritors

There are some ways that can help you reduce the costs incurred by your legal heirs, such as the ones mentioned below:

Name a beneficiary and avoid probate:

Probate can cost your family members years of legal battles and hefty fees paid to lawyers. Not only may it cause financial loss but it may also disrupt their peace of mind and lead to family feuds. One of the simplest ways to avoid all this chaos is to name a beneficiary on your retirement accounts. All retirement accounts have the option to name a beneficiary who could be a spouse, a child, a grandchild, etc. In the unfortunate event of your death, the person named as your beneficiary gets the ownership of your account and not the person named in your will. Hence, make sure to make a sound decision and name a beneficiary after careful evaluation. This will eliminate the need for a probate and save your loved ones thousands of dollars. You should also remember to update the names of the beneficiaries whenever a major life changing event takes place. For instance, if you get divorced or remarried, you may want to put your current spouse’s name on your retirement account and remove the ex-spouse’s name. Similarly, if you lose your spouse, you may want to add a child’s name instead. It is important to always update your accounts and match the information with the one on your will.Another thing to keep in mind while naming the beneficiary is to discuss it with the person in question. As appealing as the thought of inheriting a large retirement account may seem, it can also incur heavy income tax. In some cases, it may be better to pass on the retirement account to your spouse as spousal inheritances still reserve the right to stretch the withdrawals as per the IRS life expectancy table for RMDs. But, a non-spousal inheritor will have to withdraw the remaining balance within 10 years at all costs.

Give gifts to your children and grandchildren:

Passing on your retirement accounts can trigger heavy taxes for your children and grandchildren. The GST tax is charged at a flat 40%, which can take a large chunk out of your overall savings. Even children can be subject to high income tax depending on the tax slab they fall into. As a way out, you can divert your other assets towards your children. As of 2021, you can give gifts of up to $15,000 in a year without incurring any federal gift tax. The lifetime gift limit is $11.7 million in 2021 for an individual. So, you can give your children some of your assets in gifts and avoid any tax liabilities. You can use the funds from your retirement accounts to purchase other assets for your children instead of passing on the account directly.

Be careful when you select a state to retire:

States like Connecticut, Hawaii, Rhode Island, Massachusetts, Kentucky, Nebraska, New Jersey, New York, Vermont, Minnesota, and Washington charge state tax on inheritance. Connecticut, Illinois, Hawaii, Rhode Island, Maine, Minnesota, Oregon, Massachusetts, New York, Vermont and Washington charge only an estate tax. Iowa, Nebraska, New Jersey, Pennsylvania, and Kentucky charge only an inheritance tax. Maryland is the only state that charges both inheritance and estate tax.A lot of factors can determine where you settle after retirement, and taxes may not always make it to the top of the list. But it is still advisable to consider them. State taxes can amount to a lot of money, especially in the case of large estates. So, choose wisely.

To conclude

Retirement accounts and estate planning need to go hand in hand. You should keep in mind to always update the beneficiary names as per your current relationship status and family needs. Large retirement accounts can result in high taxes, but there are some ways to reduce the overall output. So, plan in advance and discuss your options with a professional financial advisor before you put an estate plan in place.