Retirement Plan Accounts: Planning Ahead to Meet Your Goals and Save Taxes

Retirement assets in the United States reached a record total of $14.5 trillion in 2005. Americans have put away one-third of all household financial assets in tax-deferred retirement accounts, including traditional individual retirement accounts (IRAs), employer-sponsored 401(k)s and 403(b)s. For many Americans, qualified plans and IRAs represent the largest part of their estates which, in some cases, is much larger than the value of their homes.

At death, distributions of retirement plan proceeds to a beneficiary results in sobering tax consequences since every dollar received is subject to ordinary income taxation. So, for example, if a child-beneficiary inherits a $800,000 traditional IRA account from a parent, and elects (or is forced into) a lump sum distribution, income taxes can reduce the value of that IRA by as much as 40%. If estate taxes apply, the plan's value could be reduced by much more!

There are ways to avoid this.

If the retirement plan so allows, the beneficiary can elect to receive minimum distributions over his/her lifetime. This option defers payment of the income tax on amounts yet to be received. Most importantly, the principal remaining inside the inherited retirement account continues to enjoy tax deferred growth over the child's life expectancy. So, as the child grows older, the minimum distributions from the inherited retirement account will grow in size and possibly provide the child with a lifetime of income (aka stretch out).

Basic retirement account planning is a simple process:

Step 1. Contact your financial advisor or employee benefits director. Have them review with you the beneficiary designations for each of your retirement accounts to make sure they represent your best interests.

Step 2. Updated beneficiary designations are absolutely crucial. For example, if a parent dies before the age of 70 1/2 with no beneficiary on their retirement plan, or if the beneficiary is my estate, only five-year or outright distribution options are available to a beneficiary.  If the retirement plan is not stretch friendly, then your financial advisor can find a more suitable plan, one which includes this feature among others.

Step 3. For example, most 401(k) plans are not stretch friendly. Many employers do not want to manage the retirement account after the employee's death. As a result, the employer forces the beneficiary to take an outright lump sum distribution, resulting in substantial reductions in the account's value due to taxes. If the stretch option is important to you, your financial advisor may be able to affect a tax-free transfer from the 401(k) plan to a self-directed, stretch friendly IRA.

 With careful advanced planning, you can meet your retirement goals while saving taxes for beneficiaries.