1. Introduction
How would you like to turn your modest tax-deferred account into millions
for your family? Depending on whom you name as beneficiary, you can keep
this money growing tax-deferred for not only your and your spouse's
lifetimes, but also for your children's or grandchildren's lifetimes. That
can turn even a modest inheritance into millions.
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2. Don't I have to use this money for my retirement?
When you reach a certain age, usually 70 1/2, Uncle Sam says you must start
taking your money out. (This is called your required beginning date.) But if
you don't use all this money before you die, naming the right beneficiary
can keep it growing tax-deferred for decades.
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3. How much will I have to take out?
Calculating the amount you must withdraw each year (your required minimum
distribution) is much easier now than it used to be. Each year, you divide
the year-end value of your account by a life expectancy divisor from the
Uniform Lifetime Table (provided by the IRS). The result is the minimum you
must withdraw for that year. You can always take out more.
For example, the divisor at age 70 is 27.4. If your year-end account balance
is $100,000, you divide $100,000 by 27.4, making your first required minimum
distribution $3,650. Each year the divisor is smaller, but it never goes to
zero. Even at age 115 and older, the divisor is 1.9. "To recalculate or not
to recalculate" is no longer an issue. Everyone now gets the benefit of
recalculating their life expectancy.
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4. Doesn't my beneficiary affect my distribution?
Not any longer. Now, almost everyone uses the same chart to calculate
distributions, even if you have no beneficiary. After you die, distributions
are based on your beneficiary's life expectancy (or the rest of your life
expectancy if you die without one.) Naming the right beneficiary is still
critical to getting the most tax-deferred growth. That's much easier to do
now, because you are no longer locked into the beneficiary you name when you
take your first distribution.
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5. Whom can I name as beneficiary?
You have five basic options: your spouse (if married); your children,
grandchildren or other individuals; a trust; a charity; or some combination
of the above.
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6. Option 1: Spouse
Most married people name their spouse as beneficiary. And, in most cases,
this will be your best option, because 1) the money will be available to
provide for your surviving spouse and 2) it gives you the spousal rollover
option.
Also, if your spouse is more than ten years younger than you are, you can
use a different life expectancy chart that makes your required distributions
even less. (This lets the tax-deferred growth continue longer on more
money.)
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7. How does the spousal rollover option work?
If you die first, your surviving spouse can "roll over" your tax-deferred
account into his/her own IRA, further delaying income taxes until he/she
must start taking required minimum distributions at age 70 1/2.
When your spouse does the rollover, he/she names a new beneficiary,
preferably someone much younger, as your children and/or grandchildren would
be. After your spouse dies, the beneficiary's actual life expectancy can be
used for the remaining required minimum distributions. The results, shown in
the chart below, can be phenomenal.
For example, let's say your grandson is 20 when he inherits a $100,000 IRA
from your spouse. Over the next 63 years (the life expectancy of a
20-year-old), the $100,000 IRA can provide him with over $1.7 million in
income!
Under current IRS policy, your spouse can do this rollover and stretch out
the IRA even if you had started taking required minimum distributions before
you died.
*****
TOTAL INCOME FROM IRA OVER BENEFICIARY'S LIFETIME*
Age (20), Life Exp. (63.0)
Value of IRA When Inherited by Beneficiary ($50,000) = $882,865
Value of IRA When Inherited by Beneficiary ($100,000) = $1,765,731
Value of IRA When Inherited by Beneficiary ($500,000) = $8,828,658
Age (30), Life Exp. (53.3)
Value of IRA When Inherited by Beneficiary ($50,000) = $526,612
Value of IRA When Inherited by Beneficiary ($100,000) = $1,053,225
Value of IRA When Inherited by Beneficiary ($500,000) = $5,266,128
Age (40), Life Exp. (43.6)
Value of IRA When Inherited by Beneficiary ($50,000) = $321,210
Value of IRA When Inherited by Beneficiary ($100,000) = $642,421
Value of IRA When Inherited by Beneficiary ($500,000) = $3,212,106
Age (50), Life Exp. (34.2)
Value of IRA When Inherited by Beneficiary ($50,000) = $201,067
Value of IRA When Inherited by Beneficiary ($100,000) = $402,134
Value of IRA When Inherited by Beneficiary ($500,000) = $2,010,671
* Assumptions: 7% annual return; only required minimum distributions
withdrawn. Income subject to income taxes.
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8. What happens if my spouse dies first?
If you don't remarry, you lose the rollover option. (It is only available to
spouses.) This used to be a problem, because distributions after your death
would still be based on your and your deceased spouse's life expectancies.
But now you can name a new beneficiary, and after you die distributions will
be based on the new beneficiary's life expectancy.
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9. Are there any disadvantages of naming my spouse?
Your spouse will have full control of this money after you die and is under
no obligation to follow your wishes. This may not be what you want,
especially if you have children from a previous marriage or feel that your
spouse may be too easily influenced by others after you're gone.
Also, if your spouse becomes incapacitated, the court could take control of
this money. It could be lost to your spouse's creditors. And, finally,
naming your spouse as beneficiary can cause your family to pay too much in
estate taxes. (More about this later.) If any of this concerns you, keep
reading.
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10. Option 2: Children, Grandchildren, Others
If your spouse will have plenty of assets after you die, if you have reason
to believe your spouse will die before you, or if you are not married, you
could name your children, grandchildren or other individuals as
beneficiary(ies).
This will let you stretch out your account without the spousal rollover.
Remember, after you die, the distributions can be paid over your
beneficiary's life expectancy.
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11. Are there any disadvantages?
Anytime you name an individual as beneficiary, you lose control. After you
die, your beneficiary can do whatever he/she wants with this money,
including cashing out the entire account and destroying your carefully made
plans for long-term, tax-deferred growth. The money could also be available
to the beneficiary's creditors, spouses and ex-spouses. And there is the
risk of court interference at incapacity. If any of this concerns you,
consider using a trust.
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12. Option 3: Trusts
Naming a trust as beneficiary will give you maximum control over your
tax-deferred money after you die. That's because the distributions will be
paid not to an individual, but into a trust that contains your written
instructions stating who will receive this money and when.
For example, your trust could provide income to your surviving spouse for as
long as he or she lives. Then, after your spouse dies, the income could go
to someone else. The trust could even provide periodic income to your
children or grandchildren, keeping the rest safe from irresponsible spending
and/or creditors.
While you are living, the required minimum distributions will still be paid
to you over your life expectancy. After you die, the required distributions
can be paid to the trust over the life expectancy of the oldest beneficiary
of the trust.
The trustee can withdraw more money if needed to follow your instructions,
but the rest can stay in the account and continue to grow tax-deferred. You
can name anyone as trustee, but many people name a bank or trust company,
especially if the trust will exist for a long period of time.
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13. Are there any disadvantages?
You will not be able to provide for your spouse and stretch out the
tax-deferred growth beyond your spouse's actual life expectancy. That's
because you must use the life expectancy of the oldest beneficiary of the
trust which, in this case, would probably be your spouse.
Also, many trusts pay income taxes at a higher rate than most individuals,
but this only applies to income that stays in the trust. (If you have a
revocable living trust, this would only happen after you die.) Distributions
from your tax-deferred account that are paid to the trust are subject to
income taxes. And if the money stays in the trust, the higher tax rates
would apply. But usually this is not a problem because the trustee
distributes the money to the beneficiaries of the trust, who pay the income
taxes at their own rates.
Finally, the trust must meet certain IRS requirements, including that it is
a valid trust under state law.
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14. Option 4: Charity
If you are planning to leave an asset to charity after you die, a
tax-deferred account can be an excellent one to use. That's because the
charity will pay no income taxes when it receives the money. And the account
will not be included in your taxable estate when you die, reducing the
amount your family may have to pay in estate taxes. (More later.)
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15. Option 5. Split Your IRA Into Smaller Ones
You don't have to choose just one of these options. You can split a large
IRA into several smaller ones and name a different beneficiary for each one.
(If your money is in a company plan, you can roll it into an IRA and then
split it.)
If you name several beneficiaries for one IRA, you must use only the oldest
beneficiary's life expectancy. But with separate IRAs (one for each
beneficiary), you can use each one's life expectancy, giving you the maximum
stretch out.
This is especially important if a charity is involved. It has a life
expectancy of zero, so the IRS would consider it the oldest beneficiary.
Depending on when you die, this could cause the entire IRA to be paid out in
just five years.
If you divide your IRA now, you will need to calculate a distribution for
each IRA, but it can be worth the trouble. Under the new rules, your IRA can
be divided even after you die. Splitting a large IRA can also save estate
taxes.
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16. What are estate taxes and why should I care?
Estate taxes are different from, and in addition to, income taxes. When you
die, your estate will have to pay estate taxes if its net value (including
your tax-deferred accounts) is more than the amount exempt at that time. In
2004, the estate tax "exemption" is $1.5 million. Every dollar over this
amount is taxed, starting at 45% and going up to 48%.
Estate taxes must be paid in cash, usually within nine months of your death.
If money must be withdrawn from a tax-deferred account to pay the estate
taxes, the result can be disastrous, because income taxes must be paid on
the money that is withdrawn to pay the estate taxes.
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17. What can I do about estate taxes?
You can reduce your taxable estate by giving some assets to your loved ones
now. You can buy life insurance to pay estate taxes at a reduced cost. And,
if you are married, make sure you use both your estate tax exemptions.
You see, everyone is entitled to an estate tax exemption. But many married
couples waste one when they leave all their assets to each other. Currently,
you can leave your spouse an unlimited amount of assets when you die and
there will be no estate taxes at that time. But when your spouse dies later,
he or she will only be entitled to one exemption. That can cause your family
to pay too much in estate taxes.
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18. How can splitting my IRA help?
Any assets you own (including a tax-deferred account) that you leave to
anyone other than your spouse (your children, grandchildren or a trust) can
use your exemption. Splitting a large IRA into smaller ones will make this
easier to do.
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19. What if I'm not married?
If you are single, naming a beneficiary(ies) will be less complicated
because you have just one estate tax exemption and there will be no spousal
rollover option to consider.
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20. When can I change my beneficiary?
Under the new rules, you can change your beneficiary at any time while you
are living, and the distributions after you die will be paid over that
beneficiary's life expectancy.
In fact, now your final beneficiaries do not have to be determined until
September 30 of the year after the year you die, which allows for some neat "clean-up" planning to be done after you're gone. For example, your spouse
could "disclaim" some benefits so a grandchild could inherit. No new
beneficiaries can be added after you die; you must have the right
beneficiaries named on your account before then.
Some employer-sponsored plans (401(k), pension or profit sharing plans,
etc.) have restrictions on beneficiary options. If your plan will not let
you do what you want, rolling your money into an IRA will usually give you
more options. If your money is in an IRA and the institution will not agree
to your wishes, move your IRA to one that will.
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21. What about the new Roth IRA?
If you qualify, you may want to convert some or all of your tax-deferred
money into a Roth IRA. You'll have to pay income taxes on the amount you
convert, but it can be well worth it. If you qualify, you can also set up a
new Roth IRA and make after-tax contributions to it.
Unlike a traditional IRA that requires you to start taking money out at 70
1/2, with a Roth IRA there are no required minimum distributions during your
lifetime. And, generally, after five years or age 59 1/2 (whichever is
later), all withdrawals are income tax-free. So you can leave your money
there, growing tax-free, for as long as you wish.
You can stretch out a Roth IRA just like a regular IRA. After you die,
distributions can be paid over the actual life expectancy of your
beneficiary. Your spouse can even do a rollover and name a new beneficiary.
And, remember, all distributions to your beneficiaries will be income
tax-free.
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22. Do I need professional assistance?
Yes, especially if you have a sizeable amount in tax-deferred plans and your estate is large enough to pay estate taxes. The rules are still complicated and loaded with tax traps and penalties. Also, any time you name someone besides your spouse as beneficiary, you need expert advice.
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