A few years ago, the US News and World Report estimated that Americans held over $8.5 trillion in their IRAs and 401K plans. Most plan participants expect to use the money for their retirement needs, but a substantial portion of this money will actually pass to the named beneficiaries of account holders. Here are six important things that people need to know.
An IRA owner may not take distributions from their IRA or 401K until they turn age 59-1/2. There is a 10% penalty for distributions prior to age 59-1/2, unless the distribution falls into a narrow exception. Age 70-1/2 is the age at which a participant MUST start taking required minimum distributions from a traditional IRA or 401K.
At death, any money remaining in an IRA or 401K will pass to the beneficiary or beneficiaries designated by the account owner (plan participant.) The money will not be passed according to a participant’s Will, unless no surviving beneficiaries have been named, in which case the account will become part of the probate estate of the decedent.
If the plan participant has not turned 70-1/2 before his or her death, then a beneficiary who is not the spouse of the deceased accountholder has three options. First, the beneficiary can take a lump-sum distribution of the entire amount. In that case, income taxes will be due on the distribution. There is no 10% penalty.
Second, the beneficiary can use what is known as the “five-year method,” in which the decedent’s account is transferred into an inherited IRA account in the name of the beneficiary and the inher-ited IRA assets are paid out in five equal annual install-ments. Income tax is due each year on distributions as they are made.
Third, a beneficiary may transfer the account into an inherited IRA account in his or her own name and take distributions based on life expectancy using IRS life expectancy tables. Each year a certain percentage (minimum distribution) of the IRA assets are paid out of the IRA to the beneficiary. This third method, which is sometimes known as a stretch IRA, maximizes the amount of tax deferral so long as the beneficiary is careful to follow the required minimum distribution rules each and every year.
If the deceased accountholder had already turned 70-1/2, then the five-year option goes away; however, a beneficiary may still use either the lump-sum method or the life expectancy distribution method.
The biggest benefit of the stretch IRA method is that a beneficiary retains full flexibility over account assets. The beneficiary must take the required minimum distribution, but they are not limited to that minimum amount. The beneficiary may always take more than the minimum in any year and may take all of the money whenever they want.
A surviving spouse may utilize any of the inherited IRA options discussed above. In addition, a surviving spouse has the option to “rollover” an inherited IRA or 401K account into his or her own IRA account. This gives the spouse the option to delay distributions until age 70-1/2. This is often the most desired option for surviving spouses. However, a surviving spouse that is under age 59-1/2 needs to be careful. If the surviving spouse chooses to establish a rollover account in his or her own name, he or she will be penalized for taking distributions before age 59-1/2.
When a beneficiary is named on an IRA or 401K account, they are in control of the distributions from the account. If the beneficiary is a minor, a person who cannot properly handle money, or a special needs individual who is receiving government assistance, then the beneficiary designation should indicate that the account should be transferred to a trust for the benefit of the beneficiary.