What Kind of Tax Bill Are You Leaving for Your Beneficiaries?

Are you one of the millions of Americans using qualified accounts such as 401(k) plans or traditional IRAs to save for retirement? They make for effective saving tools, primarily because they offer tax-deferred growth. That means you don’t have to pay taxes on your earnings as long as the funds stay in the account.

You can’t delay those taxes forever, though. With the exception of the Roth IRA, most qualified accounts have taxable distributions, which means you have to pay income taxes on withdrawals.

And you’re not the only one who could face distribution taxes. Most qualified plans’ distributions are also taxable for beneficiaries. That means your loved ones could get a sizable tax bill along with their death benefit from your IRA or 401(k). If it’s large enough, it could push them into a higher tax bracket.

Fortunately, with some careful planning, it’s possible to reduce the impact that taxes will have on your loved ones. Below are a few ways you can minimize your beneficiaries’ tax burden after you pass away:

Pay attention to required minimum distributions (RMDs).
Your typical 401(k) or IRA requires you to take distributions when you turn 70½ years old. They’re based on your life expectancy, which means the younger you are, the lower your RMD will be. As you get older, that number will increase.

It’s important to take your RMD, because if you fail to do so, you’ll face an excise tax that equals 50 percent of the missed distribution.1 What’s more, if you fail to pay your excise tax, it may have to be paid by your beneficiaries or your estate. They may be able to request a waiver, but it’s not guaranteed. You can avoid exposing them to additional taxes and fees by taking your RMDs as scheduled.

Don’t forget to name beneficiaries.
A big benefit of qualified plans is that they let you name one or more beneficiaries. When you pass, the remaining funds in your IRA or 401(k) are paid directly to your heirs and bypass probate. This is good news, because probate can be a lengthy process that often comes with steep administrative and legal fees.

If you fail to name beneficiaries, or if your beneficiaries pass away before you, the funds in your qualified accounts will likely be paid out to your estate. That means they will have to go through the probate process. It’s not a bad idea to review and update your beneficiaries regularly. This will save your loved ones time and money after you pass.

Communication is key.
One of the cornerstones of any estate plan is communication. If you don’t let your beneficiaries know what your intentions are, they won’t be able to plan appropriately. Your loved ones will undoubtedly be grateful that you’ve chosen to leave them money, but the tax liability associated with those funds is another story. A large death benefit might push them into a higher tax bracket and force them to pay more taxes than they normally would.

Your heirs do have the option to take one lump-sum payment, and they could have other options as well. For example, they might have the chance to stretch the payment over several years or even across their lifetime. Doing so can help spread out the payments and their tax burden. By discussing in advance, they can better understand their options and plan accordingly.

Ready to make the final planning decisions before you retire? Let’s talk about it. Contact us at Gallagher Financial Group for more information. We welcome the chance to help you analyze any remaining questions and develop a strategy. Let’s start the conversation today.

1https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
 
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