If you make the right moves throughout your working career, you can put yourself in a position to retire with comfort. If you are like most people, an individual retirement account will be part of the plan.
In the event that you have to draw from your account, it will be there, but you may find that you never need the money in your account. Of course, you may come to the realization that the account will become part of your estate before you actually retire.
With this in mind, I will provide an explanation of the differences between the two commonly used individual retirement accounts and look at the inheritance planning implications.
With a Roth individual retirement account, you make contributions after you pay taxes on the income. You are allowed to start to withdraw funds without being penalized when you are 59 ½ years old. If you choose to do so, you can continue to put money into the account indefinitely.
Because you already paid taxes, if you do take distributions, they are not taxable. I say “if” because you are never required to take money out of a Roth individual retirement account.
The rules are the same for a traditional individual retirement account in some ways. Penalty-free withdrawals are allowed when you are 59 ½, and you can continue to put money into the account for an open-ended period of time.
When it comes to taxation, the situation is reversed. You contribute into a traditional account before you pay taxes on the income. This is great when you are younger, because you pay taxes on less income each year.
On the flip side, you do have to report the distributions as taxable income, and you must take required minimum distributions when you are 72 years of age.
Individual Retirement Account Beneficiaries
Now that I have provided the necessary background information, lets drill down to the inheritance planning implications.
If you leave an IRA to your spouse, they would have two options. They could roll it over into their own account, or they could retitle it as an inherited account and act as the beneficiary.
For non-spouse beneficiaries, the arrangement is different. Regardless of the type of account that is inherited, the beneficiary would be forced to take required minimum distributions.
Roth account beneficiaries receive the distributions in a tax-free manner, but traditional account beneficiaries have to claim the income.
In December of 2019, the SECURE Act was passed by Congress, and it was signed into law. This legislative measure impacted the rules for individual retirement accounts.
Prior to its enactment, there was a very commonly used estate planning strategy called the “stretch IRA.” To implement this approach, the beneficiary would take only the minimum that was required by law for the maximum period of time.
This would be quite beneficial if the account was well-funded so it could remain viable for many years. The stretch IRA was best utilized by Roth account holders.
Now, all of the assets must be taken out of either type of account within 10 years, so the stretch possibilities are now limited. This means that, under the new law, your non-spousal beneficiaries will have to pay income tax on the whole of your traditional IRAs within ten years, and without proper planning, both the Roth and traditional IRAs will be subject to your beneficiaries’ creditors and divorces.
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