Last Modified on May 26, 2020

People make savings and investments keeping in mind the needs of their families. Most of the time, one generation is diligent and resourceful to turn their savings into heritage for the upcoming generations. There are several instances where people are still enjoying the earnings from their forefathers’ investments. 

However, as someone looking to build a pool of wealth for your loved ones, only saving money is not enough. There are several other aspects related to money that require equal consideration, one of which is taxation. Another important factor that needs to be accounted for while dealing with wealth is to decide your beneficiaries in case of your demise. 

Roth IRAs (Individual Retirement Account) and 401(K) investments are quite popular among investors who wish to leave an inheritance to their heirs. This is so because these accounts offer tax benefits and do not account for RMDs or required minimum distributions immediately. Generally, the contributions made under a Roth IRA are tax adjusted and once you have held a Roth IRA for at least 5 years and are at the age of 59.5, you can take tax-free distributions from that account. However, when you pass on this heritage to your heirs, they may or may not be able to enjoy the tax-free status of this account. This entirely depends on how you manage your Roth IRA. 

Here are three estate planning mistakes that you must avoid while dealing with your Roth IRA and 401(k) account:

Not naming a beneficiary

The biggest and most common mistake that investors commit is not naming the beneficiary of their estate. In most IRAs, of the several clauses, this is generally found empty. One of the main reasons for this mistake is that people open their IRAs quite early in life (usually before getting married and having children) and then forget about it. As time passes, the thought of designating a beneficiary for their IRA or for that matter all other savings and investment accounts, simply vanishes from their mind. 

Not naming a beneficiary can prove to be a costly affair since the decision and inheritance depends upon your will. If you do not have a will, your heirs will need to hire a lawyer and run around courts to get the rightful ownership of their legacy. This will prove to be expensive in terms of time, money, and effort.

It is always advisable to name a beneficiary as and when you open your IRA, whether it is your parents or siblings. As your family grows or evolves, you must remember to make the desired changes.  Doing so will ensure that your spouse and children get the intended benefits without any hassles and complexities. 

Committing a wrong beneficiary selection

The second common mistake people make is naming the wrong beneficiary when rushing to do so. While most couples practice naming each other as beneficiaries in their IRAs and 401(K)s, this may prove to be a wrong decision in the case of Roth IRAs. 

A huge advantage in the case of Roth IRAs is that if you name a younger beneficiary, like your children, they will be able to extend the distribution period for 10 years under the SECURE Act. In certain cases where the beneficiary is either chronically ill, disabled, under the age of 18, or is no more than 10 years younger to the original owner, the limit can be stretched further and be extended throughout their lifetime.

Under the Roth IRA accounts, the distributions made are tax-free in nature and even the wealth appreciation is not taxed upon the death of the original owner. However, you need to be careful about other taxation rules that may apply to younger beneficiaries inheriting the legacy. Consulting an expert in such cases could be helpful. 

Avoiding RMDs

RMDs are required minimum distributions that need to be taken at regular intervals as a general rule. However, when the original account owner passes away, heirs generally neglect taking these distributions. If the beneficiary is not the spouse of the original owner, then they need to start taking out RMDs with effect from 31st December of the next year in which their original owner died.  

Upon failing to take out the RMD at regular intervals, the beneficiaries may be forced to withdraw the complete amount within a span of 5 years. This span otherwise could be extended to 10 years if the beneficiary maintains discipline in taking out the RMDs. 

Also, since the beneficiaries would have violated the RMD rules, they will be liable to pay taxes and penalties accounting for a considerable amount. 

To sum it up

Dealing with money requires due diligence and extra caution, whether it is for your current use or for an attempt to leave a legacy for your future generations. A sophisticated financial system can account for ease and transparency in monetary matters but can also be highly penalizing if not dealt with carefully. Remember that when you are planning to leave a fortune for your heirs, money is not the only thing you need to think of. There are several other important aspects that need attention and planning. 

If you think that you are making any of these mistakes with your IRA and 401(k) account, you can consult financial advisors and work towards rectifying them.