You have taken care of your children your entire lifetime and are now enjoying a successful retirement. Inevitably, you are getting older and thinking about your legacy. Is there a way to leave your 401k or your IRA to your children while leaving as little to Uncle Sam as possible? After all, it took you forty years or more to accumulate this nest egg, and now the tax man
Required Minimum Distribution (RMD)
When you turn the magical age of 70 ½ you are required to take a minimum distribution from your 401k, IRA, 403b or any other qualified retirement plans. This minimum distribution is commonly known as an RMD. To make matters worse, you are required to take these RMDs, not only in the year you turn 70 ½, but also for the rest of your life. You may ask, ‘What is the big deal?’ Remember, when you take withdrawals from these accounts, 100% of the withdrawal is taxed at ordinary income tax rates. And the older you get the more you are required to withdraw from your account. If you happen to forget to take your RMD in a year, the penalty is 50% of what you were required to take. So, are there withdrawal options to consider that can end up leaving your children in a much better place? Let’s delve into a few.
Turning RMD Pain into Gain
One strategy is to take your RMD and purchase life insurance to replace the value of your qualified plan. And remember, proceeds are typically 100% tax-free from a life insurance policy. Another strategy, if you are charitable-minded, is to change your beneficiary on your qualified plan to a charity. Why would you do this? Let’s say you have a 401k and the value is $500,000. In this example you would buy a $500,000 life insurance death benefit, which would be 100% tax-free to your beneficiaries, and the $500,000 in your 401k would go to the charity of your choice. If you leave your 401k to a charity, guess what, no tax. Uncle Sam is left holding out empty hands.
Stretch 401k
A third strategy is for your beneficiaries to do what is called a stretch option, which I will quickly explain. When your 401k goes to your children, for example, they still will be required to take an RMD from the account, though it will be a lesser amount, because the required withdrawals are based on their longer life expectancy. Of course, they will still have to pay tax on the distribution. By choosing this strategy, this will allow the remaining assets in your account to continue growing. Imagine the growth that could occur over another 20 or 30 years. This could have a huge impact on their own retirement planning.
Conversion
One more strategy would be to convert your 401k to a Roth 401k or Roth IRA. In the example above if you were to convert the entire $500,000 to a Roth, then you are in for a big surprise. You will owe tax on $500,000 the same year you convert. Chances are you will not be happy, but I bet Uncle Sam will be. A better option to consider may be to convert over a period of years. Let’s say 10 years. You would convert $50,000 each year over the next 10 years. The difference can be huge as far as taxes go. Would you rather pay tax on the entire $500,000 in one year or pay taxes on the smaller amount each year over a ten-year period? The big reason to consider this strategy is once you convert to a Roth, then your withdrawals are 100% tax-free. You can’t get away from paying taxes on the $500,000, but with proper planning, you can certainly lessen the tax. Note that there are different rules for leaving your qualified plan to your spouse versus your children.
Don’t be afraid to seek financial and estate planning help. Tax and legacy planning can be pretty complicated and laws tend to change regularly. Remember smart financial decisions will impact the both the quality of your life and legacy.