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Inherited 401(k) Accounts

What Can I Do with an Inherited 401(k)?

Inheriting a 401(k) at the death of the account owner isn’t always as simple as inheriting a home or a piece of jewelry. The IRS has rules that 401(k) beneficiaries must follow that say when and how much tax they’ll pay to inherit someone else’s retirement plan. If you’re currently the beneficiary of a 401(k) or you’ve recently inherited one, here are some important things you need to know.

Smart Assets’s recent article entitled “A Guide to Inheriting a 401(k)” explains that if a spouse of the account owner waives their right to inherit a 401(k) or the account owner is unmarried, they can leave their account to whomever they want at their death.

An inherited 401(k) is taxed is based on three key factors: (i) your relationship to the account owner; (ii) your age when you inherit the 401(k); and (iii) the account owner’s age when they die.

There’s also several ways to take a distribution from a 401(k) when you’ve inherited it: you can do a lump sum, periodic payments, or distributions stretched out over your life expectancy.

If you inherit a 401(k) from your spouse, what you decide to do with it and the subsequent tax impacts may be based primarily upon your age. If you’re under age 59½, you have a choice of three things:

  1. Keep the money in the plan and take distributions. You can take withdrawals from the account without the 10% early withdrawal penalty. You’d still pay regular income tax on any distributions you take. If your spouse was age 70½ or older when they passed away, you would have to take required minimum distributions from this account. There’d be no early withdrawal penalty. However, you’d pay income tax on the withdrawals. If the spouse was younger than 70½ when they died, you could wait to take RMDs until you turn 70½.
  2. Move the money to an inherited IRA. This is an IRA that’s designed to hold rollover funds from an inherited retirement plan, including 401(k)s. You can make withdrawals without any early withdrawal penalty. With this type of account, you’d need to take RMDs. However, the amount would be based on your own life expectancy, not the amount your spouse would have been required to take.
  3. Move the money to your own IRA. If you already have an IRA, you could roll an inherited 401(k) into it with no tax penalty. However, if you’re under age 59½ when you execute the rollover, the withdrawal will be treated like a regular distribution, so you’ll pay income tax on the full amount, along with the 10% early withdrawal penalty. If you’re over age 59½, you won’t pay an early withdrawal penalty with any of these options. If your spouse was taking RMDs from their 401(k) when they died, you’d have the option to continue taking them or delay taking them until you turn 70½. If you’re already 70½ or older, you’d need to take RMDs, regardless of whether you leave the money in the 401(k), transfer it to an inherited IRA or roll it over to your existing IRA.

If you inherit a 401(k) from someone other than your spouse, your options are linked to how old the account owner was when you inherited the plan and the plan’s distribution rules. If the account owner hadn’t yet turned 70½, the plan may let you spread distributions out over your lifetime or spread them out over a five-year period. If you take the five-year option, you may have to fully withdraw all of the account assets by the end of the fifth year following the account owner’s death. In either case, you’d pay income tax on the withdrawals.

You could also roll the account over to an inherited IRA, if the plan permits this. Here, the RMDs would be based on your life expectancy, assuming the account owner hadn’t started taking them yet. If they had started with their RMDs, you’re required to continue taking those distributions. However, you could base the distribution amount on your life expectancy, rather than that of the account owner.

Speak with an experienced estate planning attorney to help you determine the route that makes the most sense to reduce taxes, while planning ahead for the future.

Reference: Smart Asset (October 22, 2019) “A Guide to Inheriting a 401(k)”

Suggested Key Terms: Asset Protection, Tax Planning, Financial Planning, Inherited IRA, Roth Conversion, Required Minimum Distribution (RMD)

Making a Beneficiary Designation

The Often-Overlooked Beneficiary Designation

Remember the life insurance policy that you bought when you first became a parent and bought your first home? The one you haven’t thought about much in decades, except to pay annual or semi-annual invoices? Think about the last time you reviewed it to see what kind of coverage it offers, and who you named as a beneficiary. Beneficiary designations and estate planning go hand in hand.

If you can’t remember, you’re among many people who have assets with beneficiary designations and have no idea what those designations are. This is just one of a number of problems that arise concerning beneficiaries, as noted in the article “Five mistakes to avoid when naming beneficiaries” from the News-Herald.

1–Not naming beneficiaries on accounts. You need to name a beneficiary on every account that provides this option. That includes all investment, retirement and banking accounts and insurance policies. If you don’t name a beneficiary on one or more accounts, your estate will become the beneficiary and your loved ones will need to go through the probate process. Most families try to avoid this through the creation of an estate plan. If a retirement plan asset goes through probate, like an IRA, your loved ones may lose the ability to use the “stretch” payouts based on their own life expectancy, when the tax-advantaged status for a retirement asset is gone when the asset goes to an estate.

2—Forgetting to name a contingency beneficiary on all accounts. Most people name the same person—usually a spouse or a child—as the primary beneficiary on all their accounts. That’s all well and good. However, if that person passes away before you and no contingent beneficiary is named, it’s the same thing as having no beneficiary named. If you and the primary beneficiary die at the same time and there’s no contingent beneficiary, funds go into the probate process.

3—Not using specific and correct names. Stating that your daughter, parents or an aunt is your beneficiary creates big problems for distributing assets. This becomes especially problematic, when there are stepchildren involved. Most states don’t recognize stepchildren as family members, even if you do. If a family member learns that your estate is being probated and tries to make a claim on your estate, just naming “my aunt” could leave the door open for a valid claim. Use the full and proper name of your beneficiaries.

4—Neglecting to update beneficiaries regularly. Just as you must update your will every three or four years, your beneficiaries need to be updated. If a beneficiary has died, married or you are no longer close with them, you need to make those changes. If you divorce and haven’t changed your life insurance beneficiary from your ex-spouse, they could inherit the proceeds.

To be sure that your assets are passed to the people you want, be sure that your estate plan and your beneficiary names are all up to date. Talk with your estate planning attorney every few years to be sure that your wishes are followed.

Reference: News Herald (Nov. 12, 2019) “Five mistakes to avoid when naming beneficiaries”

Suggested Key Terms: Estate Planning Attorney, Beneficiaries, Divorce, Stepchildren, Contingent Beneficiary, Designation

Probate Court Hearing

What Is Probate and How to Prepare for It?

The word probate is from the Latin word, meaning “to prove.” It is the court-supervised process of authenticating the last will and testament of a person who has died and then taking a series of steps to administer their estate. The typical situation, according to the article “Some helpful hints to aid in navigating the probate process” from The Westerly Sun, is that someone passes away and their heirs must go to the Probate Court to obtain the authority to handle their final business and settle their affairs.

Many families work with an estate planning attorney to help them go through the probate process.

Regardless of whether there is a will, someone, usually a spouse or adult child, asks the court to be appointed as the executor of the estate. This person must accomplish a number of tasks to make sure the decedent’s wishes are followed, as documented by their will.

People often think that just being the legally married spouse or child of the deceased person is all anyone needs to be empowered to handle their estate, but that’s not how it works. There must be an appointment by the court to manage the assets and deal with the IRS, the state, creditors and all of the person’s outstanding personal affairs.

If there is a will, once it is validated by the court, the executor begins the process of identifying and valuing the assets, which must be reported to the court. The last bills and funeral costs must be paid, the IRS must be contacted to obtain an estate taxpayer identification number and other financial matters will need to be addressed. Estate taxes may need to be paid, at the state or federal level. Final tax returns, from the last year the person was alive, must be paid.

It takes several months and sometimes more than a year to settle an estate. That includes distributing the assets and making gifts of tangible personal property to the heirs. Once this task is completed, the executor (or their legal representative) contacts the court. When everything has been done and the judge is satisfied that all business on behalf of the decedent has been completed, the executor is released from their duty and the estate is officially closed.

When there is no will, the process is different. The laws of the state where the deceased lived will be used to guide the distribution of assets. Kinship, or how people are related, will be used, regardless of the relationship between the decedent and family members. This can often lead to fractures within a family, or to people receiving inheritances that were intended for other people.

Reference: The Westerly Sun (Nov. 16, 2019) “Some helpful hints to aid in navigating the probate process”

Suggested Key Terms: Probate, Kinship, Inheritance, Last Will and Testament, Executor, Estate Identification Number, Estate Planning Attorney

401(k) Nest Egg

Costly Mistakes with 401(k)s and How to Avoid Them

Making sure that you handle your 401(k)s correctly, is not as easy as letting payments be automatically deducted from your wages. Here’s a look at commonly made mistakes, detailed in the article aptly named “More common 401(k) mistakes—and their consequences” from tucson.com.

Investing after-tax dollars before maxing out pretax opportunities. Some plans let you choose to contribute to your 401(k) on a pretax or after-tax basis, or both. The problem happens when the forms provide these choices, without giving an explanation of the different choices. Generally speaking, you always want to lower your W-2 earnings, by contributing pretax dollars first. Your W-2 won’t include the money you put in a 401(k) or other retirement savings vehicle.

Cashing out a 401(k) when you change jobs. This is a big and bad one. The IRS loves when you do this, because the withdrawal is taxable income that would otherwise sit in a 401(k) for years, possibly decades. One survey showed that as many as 28% of people between the ages of 35-65 did not know that some of their retirement distribution choices would trigger tax liabilities and penalties.

A better option: leave the 401(k) with your old employer, move it to your new employer’s plan if that is an option, or set up a rollover IRA with a bank or investment firm to transfer the 401(k). Do this very carefully: you are rolling over the money, not cashing it out. Don’t use the money when you move it—this is your best savings option for retirement.

Borrowing from the plan to pay for a big-ticket purchase. Yes, there may be a loan feature in your 401(k) plan. However, while this may be a blessing in an emergency, it is likely to be one of the most expensive loans you ever take. There are strict rules about paying back 401(k) loans and running afoul of them could create more problems. Read the fine print, before borrowing against your retirement fund. Remember, you are borrowing against your future.

Defaulting on a 401(k) loan. Don’t give yourself a loan from your 401(k), unless you understand all of the rules and penalties. Most 401(k) loans must be paid back within five years, unless the loan is used to purchase a primary residence. However, this is supposed to be a retirement savings account, not a house fund. You should also find out what happens if you quit or lose your job, while the loan is outstanding. The balance of your 401(k) account is often used to pay for the outstanding loan and you’ll be responsible for paying taxes on the withdrawal, PLUS a tax penalty for early withdrawal from the 401(k).

Thinking you’ve got plenty of time before retirement. The sooner you start saving for retirement, like when you receive your first paycheck, the better. Pay your future self, first. You can always get a loan for a home, a car or your children’s college education, but there’s no such thing as a retirement loan.

Reference: tucson.com (Nov. 15, 2019) “More common 401(k) mistakes—and their consequences”

Suggested Key Terms: 401(k), Retirement Savings, Pre-Tax, After Tax Dollars, Penalties, Defaulting,

Blended Family Wedding

Estate Planning in Virginia With Blended Families

The holiday season is a popular time for people to get engaged, including people who have been married before. If that’s you, understand that blending families means you’ll need to deal with inheritance and finance issues, says U.S. News & World Report’s article “6 Financial Considerations for Remarriage.” The best time to have these conversations is before you walk down the aisle, not afterwards.

Look at your budget and talk about how things will work. That includes day-to-day expenses, monthly expenses and large purchases, like houses, vacations and cars. Talk about a game plan for going forward. Will you merge your credit card accounts or bank accounts? What about investment accounts?

Financial obligations outside of the marriage. Two things to check before you wed: your divorce papers and the state’s laws. Does anything change regarding your spousal support (alimony) or child support, if you remarry? It’s unlikely that you would lose child support, but the court may determine it can be reduced. The person who is paying child support or alimony also needs to be transparent about their financial obligations.

Review insurance and beneficiaries. One of the biggest mistakes people make, is failing to update beneficiaries on numerous accounts. If your divorce papers do not require life insurance to be left for your spouse on behalf of your children (and some do), then you probably want to make your new spouse the beneficiary of life insurance policies. Investment accounts, bank account, and any other assets where a beneficiary can be named should be reviewed and updated. It’s a simple task, but overlooking it creates all kinds of havoc and frustration for survivors.

What will remarriage do to college financing options? A second marriage may increase a parent’s income for college purposes and make children ineligible for college loans or needs-based scholarships. Even if the newly married couple has not blended their finances, FAFSA looks at total household income. Talk about how each member of the couple plans on managing college expenses.

A new estate plan should be addressed, even before the wedding takes place. Remember, an estate plan is for more than distributing assets. It includes planning for incapacity, including Do Not Resuscitate Orders (DNR), powers of attorney for finances and for health care, designations of guardianship or consent to adoption, various trusts and if needed, Special Needs planning.

Create a plan for inheritance. If either spouse has children from a prior marriage, an estate plan is critical to protect the children’s inheritance. If one spouse dies and the surviving spouse inherits everything, there is no legal requirement for the surviving spouse to pass any of the deceased’s assets to their children. Even if you are in mid-life and death seems far away, you need to take care of this.

Speak with an estate planning attorney who can help you create the necessary documents. You should also talk with your children, at the age appropriate level, about your plans, so they understand that they are being planned for and will be taken care of in the new family.

Reference: U.S. News & World Report (Nov. 18, 2019) “6 Financial Considerations for Remarriage”

Suggested Key Terms: Remarriage, Power of Attorney, Guardianship, Adoption, Trusts, Inheritance

Chairs overlooking a lake

Here’s Why You Need an Estate Plan

It’s always the right time to do your estate planning, but it’s most critical when you have beneficiaries who are minors or with special needs, says the Capital Press in the recent article, “Ag Finance: Why you need to do estate planning.”

While it’s likely that most adult children can work things out, even if it’s costly and time-consuming in probate, minor young children must have protections in place. Wills are frequently written, so the estate goes to the child when he reaches age 18. However, few teens can manage big property at that age. A trust can help, by directing that the property will be held for him by a trustee or executor until a set age, like 25 or 30.

Probate is the default process to administer an estate after someone’s death, when a will or other documents are presented in court and an executor is appointed to manage it. It also gives creditors a chance to present claims for money owed to them. Distribution of assets will occur only after all proper notices have been issued, and all outstanding bills have been paid.

Probate can be expensive. However, wise estate planning can help most families avoid this and ensure the transition of wealth and property in a smooth manner. Talk to an experienced estate planning attorney about establishing a trust. Farmers can name themselves as the beneficiaries during their lifetime, and instruct to whom it will pass after their death. A living trust can be amended or revoked at any time, if circumstances change.

The title of the farm is transferred to the trust with the farm’s former owner as trustee. With a trust, it makes it easier to avoid probate because nothing’s in his name, and the property can transition to the beneficiaries without having to go to court. Living trusts also help in the event of incapacity or a disease, like Alzheimer’s, to avoid conservatorship (guardianship of an adult who loses capacity). It can also help to decrease capital gains taxes, since the property transfers before their death.

If you have several children, but only two work with you on the farm, an attorney can help you with how to divide an estate that is land rich and cash poor.

Reference: Capital Press (December 20, 2018) “Ag Finance: Why you need to do estate planning”

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