Pre-tax retirement accounts like an IRA or a 401k plan are significantly different from your other assets and understanding these differences is the first step to protecting yourself from triggering unnecessary taxes and penalties. First, they do not pass to your heirs through a will or a trust like your other assets, such as your house or checking account. Instead, they pass through a beneficiary form. (Thomas B. Gau,CPA,- Mistakes people make when they inherit an IRA)
This requires extra planning to be sure that your beneficiaries are the same as those stated in your will or a trust. For example, you might have updated your will to include a new grandchild. But, if you don’t also put the grandchild’s name down on the beneficiary form for your retirement account, they could be disinherited from their share of that account. Retirement accounts do not go through probate at the death of the retirement account owner as long as you have a person’s name down as a beneficiary. This is a powerful advantage of a retirement account since probate can be both time-consuming and expensive. (Broadridge Solutions-Understanding Probate)
Compare this with the other assets in your estate which will be subject to probate in most cases, unless you get those assets retitled in a properly drafted trust.
There are some cautions to be aware of when naming beneficiaries on a retirement account. If you put the word “estate” down as your beneficiary, or have a deceased person or a minor child listed as your beneficiary, this could cause that retirement account to end up going through probate anyway. You do not get the more favorable long-term capital gains tax treatment when you sell appreciated assets in a traditional IRA, 401k, or other pre-tax retirement account when you take the money out. Instead these funds will be taxed as ordinary income. (Broadridge Solutions-what is the capital gains tax?)
For example, let’s say I bought a stock for $10,000 dollars and 10 years later it’s worth $100,000. Let’s also assume I’m in a 24% tax bracket. This means my long-term capital gain tax rate would be 15%. If I sell the stock I will owe 15% of the $90,000 gain in taxes which would be $13,500. Now let’s change the circumstances and say I bought that same stock 10 years ago for $10,000 in a pre-tax IRA. It’s now worth $100,000 and I sell the stock and pull the money out of my IRA in the same 24% tax bracket. In most cases I would owe 24% of the $100,000 which would be $24,000. This is substantially more expensive than the $13,500 in long term capital gains tax I owed in the first example.
There is no step up in cost basis upon the death of the owner on a retirement account. Most other assets owned by an individual receive a step up in cost basis at death, which means all taxable appreciation on that asset is forgiven. (Thomas B Gau, CPA, Mistakes people make when they inherit an IRA) On the other hand, after the death of a retirement account owner, if any investment assets are sold and the beneficiaries take the money out of the retirement account, it’s fully taxable as ordinary income.
To illustrate, let’s use the previous example of buying a stock for $10,000 where it’s now worth $100,000, but instead of selling it, this time let’s assume I pass away when the stock is at $100,000. The $90,000 of capital appreciation will be forgiven and if my heirs sell the stock they will pay zero tax on this appreciation. But if I bought the same stock inside my IRA for $10,000 and I passed away when it was worth $100,000 and my beneficiary sold the stock and pulled the money out, it would be fully taxable as ordinary income. If that beneficiary was in a 24% tax bracket, they would end up paying $24,000 in taxes.
Retirement accounts cannot be gifted in their current form (some charitable exceptions apply). With non-retirement account assets, you can gift up to $15,000 a year to as many people as you want without triggering any gift tax consequences. However, if you want to gift some of your retirement account money to someone, you must first take a distribution, pay the income tax on it, and then make the gift. (Thomas B. Gau, CPA-Mistakes people make when they inherit an IRA)
For example, let’s say I pull $15,000 out of my IRA to make a gift, and I’m in a 24% tax bracket. In most cases I will have to pay tax on 24% of the $15,000, which would cost me $3,600, before I can make the gift.
You cannot title a retirement account like an IRA or 401k in the name of a trust, like you can with other assets such as your house or your investment accounts. If you do so, this would cause immediate taxation of the entire account. The “beneficiary” can be titled in the name of a trust, but the title of the retirement account itself must be in the name of a person. This means there is no estate planning document that directly regulates your retirement account. (Ed Slott and Company LLC-Naming trusts as beneficiaries) As mentioned earlier, this requires extra care to make sure that the beneficiaries on your retirement account are the same, or as close to the same as possible, to those named in your trust or other estate planning document. Otherwise you may risk accidentally disinheriting someone from receiving their share of your retirement account.
Last but not least, retirement accounts are different because you must start taking out a required minimum distribution at age 70½ that will be fully taxable, or April 1 of the year after you turn 70 1/2, if you want to take 2 taxable distributions in the same year. (Ed Slott and company,LLC-Required minimum distributions) On a larger pre-tax retirement account like an IRA this can sometimes result in pushing a person into a higher tax bracket.
Failure to take this required distribution will result in a 50% tax penalty, so this is something you want to be very careful to get done before December 31 of each year. No other assets in your estate require you to take out a required minimum distribution and pay tax on it, other than retirement accounts. Weighing these differences between retirement accounts and non-retirement assets can be the first step to helping you make better decisions on what kind of retirement accounts you should consider and how much money you should be putting into them.