Individual Retirement Accounts (IRAs) and qualified retirement plans have one thing in common: each allow the owner to designate a beneficiary to inherit the account upon the owner’s death. While neither plan type allows the current owner to transfer ownership rights during their own lifetime, they do offer unique opportunities after death, and helping your clients understand their options could help them avoid costly mistakes for their heirs.
Designated Beneficiary Defined
It is important to recognize the benefits of a proper beneficiary designation made during the owner’s lifetime, which can avoid the necessity of having a full distribution of the account subsequently taxed upon the owner’s death. In addition to the primary beneficiary, the owner should name a contingent beneficiary in the event the primary beneficiary dies before the owner, in which case the contingent beneficiary then becomes the primary beneficiary. This will help avoid losing the tax advantaged nature of the account if there is no living primary beneficiary and the account goes to probate.
“Inherited Account” Creation
Often people ask why creating an inherited account is important. The primary reason is the power of a retirement account to continue to grow tax-deferred or even tax-free prior to any distribution, as provided by the Internal Revenue Code and Treasury regulations. That opportunity can only be recognized when a designated beneficiary is created before death.
With a non-spouse designated beneficiary, when the owner dies, as long as an “inherited account” is created no later than December 31 of the year after death, that beneficiary may use their own single life expectancy to become the measuring period for continued deferral. However, to continue such tax advantage status, they must start taking an annual required minimum distributions (RMD).
For example, in any given year the beneficiary must use the prior year’s December 31 balance divided by a life expectancy factor. If the beneficiary has a 40-year single life expectancy when the account is created, the first year they must remove 1/40th of the balance and reduce that by one each year thereafter. That means the second year they would remove 1/39th, and so on, with the divisor reduced by one each year thereafter. They may always take out more than that year’s RMD, but whatever is taken out will be taxed at ordinary income tax rates. Failing to take that RMD could cause the account to no longer have the right to further tax-advantaged deferral.
There are additional options for a spouse named as a designated beneficiary: after death of the owner, they have the opportunity to roll the account over to their own account, and no RMD is mandated until they would reach age 70 ½. Another strategy is to leave the money in an inherited account and postpone RMDs until the original owner would have reached 70 ½. At that time, the spouse can roll the funds into their own account and start taking RMDs with the benefit of their own life as a measuring life. For more information on this, see IRS Publication 590.
Individual Retirement Account Variations
IRAs come in two major variations: traditional and Roth.
The traditional IRA operates as described above. That means that the account is set up for tax deferral, but there are required distributions during the owner’s lifetime which must begin no later than April 1 of the year after they turn 70 ½. This is usually accomplished with a divisor factor of a Uniform Lifetime table, which builds in a second “ghost” life expectancy 10 years younger. The traditional table would require a divisor the first year of 27.4 to determine the RMD sum, again using the value of the account as of the prior December 31.
In the case of a traditional IRA, there is typically an annual tax deduction for the sums contributed to the account each year. But if your client chose to create a Roth IRA, they are not afforded an annual tax deduction in the years contributions are made. However, a Roth account grows tax-free and distributions can be made tax-free provided the account was created at least 5 years prior and there is a triggering event. These triggers include death, disability, age 59 ½, or first time home purchase. In such cases, all distributions—both gains and principal—are tax free. Without that criteria being met, only the amount contributed can be removed tax free, while the earnings will be taxed. An additional and often advantageous feature of this account is that during the owner’s lifetime and a surviving spouse’s lifetime, no RMD needs to be taken.
However, in the case of a non-spouse being a designated beneficiary, there is still the mandate that an RMD must be taken out each year, as with a traditional IRA. However, despite mandating an RMD, the sum distributed is not taxable to the beneficiary, and the balance continues to grow tax-free thereafter. At first look, it may seem illogical that distribution is tax-free when there is an RMD; however, the government’s mandate is that the accounts not be allowed to grow tax-free in perpetuity, which the RMD accomplishes.
Qualified Plan Opportunity
A qualified retirement plan, such as a 401(k), may use a pre-tax program as well a Roth type program. Again, the pre-tax affords a tax deduction annually for the elective contribution made, while in the case of a Roth 401(k), no current tax deduction is available. In both cases, generally, the same rules as the IRA described earlier apply. A qualified plan which has a special plan provision may allow an employee the opportunity to defer taking an RMD even after they turn 70 ½. This can be plan specific and only in the case where such employee owns less than a 5% share ownership of the business entity. In that case, they would merely begin taking an RMD starting the year after they actually retire. This can be very advantageous for growing a retirement nest egg.
Making a careful review and naming a designated beneficiary means that your client’s account need not go through a court probate proceeding, since upon death of the owner there is an immediate process of giving the beneficiary the benefits of the account. All this underscores the need for proper planning during the client’s lifetime. If no primary is named, or the primary dies before the owner without any contingent beneficiary being named, the decedent’s estate in a probate proceeding will become the beneficiary. Since the estate is not a natural person it has no life expectancy and it is not afforded the stretch opportunity that would have been afforded based upon the life expectancy of a natural named beneficiary. Lastly, it is important to remember that one can create multiple designated beneficiaries, for whom separate inherited accounts can be created following the specific percent that each beneficiary is scheduled to be receiving.
Clearly, to assure that your client’s distribution wishes are met, they need to plan ahead and consider the options afforded them in the sometimes flexible, often complex tax code.
About Cetera® Advisors
Cetera Advisors LLC is an independent broker-dealer and registered investment adviser (RIA) firm offering efficient and convenient access to an extensive network of people, products and services to financial professionals. As part of Cetera Financial Group®, a leading network of independent retail broker-dealers, the firm is able to offer all the benefits of a large, well-capitalized broker-dealer, including innovative technology, leading wealth management and advisory platforms, and comprehensive broker-dealer and RIA services, with the personal relationships often found only at a boutique firm.
Cetera Advisors is a member of the Securities Investor Protection Corporation (SIPC) and a member of the Financial Industry Regulatory Authority, Inc. (FINRA). For more information, visit ceteraadvisors.com.