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.
Retirement accounts 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. You might have updated your will to include a new heir like a grandchild. However, if you do not put the grandchild’s name down as an additional beneficiary on the beneficiary form, then they could be disinherited.
Retirement accounts do not go through probate at the death of the retirement account owner as long as you have named beneficiaries.
For example, if you have an ordinary will, most of your assets in your estate will pass through probate, which can be both expensive and time consuming. On a retirement account, the funds will go directly to the beneficiaries with a minimum of time and expense.
You do not get the more favorable capital gains tax treatment for a traditional IRA, 401k, or other pre-tax retirement accounts. Your other assets that have appreciated in value are subject to reduced capital gains taxes on the gain if you sell them after one year. However, any investment assets sold at a gain inside a retirement account when distributed are taxed as ordinary income, and not at lower capital gain tax rates.
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 upon the death of the owner, eliminating all capital gains and the resulting tax owed on those assets up to the date of death. 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.
Retirement accounts cannot be gifted in their current form (some charitable exceptions apply). With non-retirement account assets you can gift up to $14,000 a year to as many people as you want without triggering any 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.
You cannot title a retirement account like an IRA or 401k in the name of a trust like you can with any other asset such as your house or your investment accounts. Remember that 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 any retirement account itself must be in the name of an individual.
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. No other assets in your estate require you to take out a minimum distribution and pay tax on it other than retirement accounts.
Also, remember that most retirement accounts are tax deferred and are subject to many different age-related tax rules which will be a subject for another day.
• Mike Piershale is president of Piershale Financial Group. If you have financial questions on this column, contact us at Piershale Financial Group, Inc., 407 Congress Parkway, Crystal Lake, IL 60014. You may also email Mike@PiershaleFinancial.com