Death and Your Tax-Favored Retirement Accounts

OK. Here’s what happens after you die. First, you get buried. Then your kids mourn. Then they wonder what kind of retirement accounts you left them. Wouldn’t you like to know how your kids will be taxed on these accounts? No? You don’t care? Well, then you can skip today’s post. But if you’re curious, read on.

Here are the ground rules. I hope they clear up a few potential misconceptions.
• Your Will is irrelevant. It’s your named beneficiary as recorded in your Beneficiary Designation Form who becomes entitled to the account. You remember that form. You filled it out thirty years ago before your second and third children were born, and then forgot about it. It’s in a drawer somewhere. Or maybe not. And it doesn’t matter if you don’t have a copy, because it’s what’s on file with the IRA or 401(k) Trustee that counts. If they haven’t lost it.
• If you’re not careful how you fill out your beneficiary form, your family can end up with unintended results. If you name your children equally as beneficiaries, it’s important to take into account the possibility that a child will predecease you. It’s not the natural order of things, but it happens. Then when you die, that predeceased child’s share might end up going to his siblings rather than his children, as most people would want. To take this possibility into account, you can name as beneficiaries, “my children, equally per stirpes.” Which is the Latin-legalese way of saying “if a child predeceases me, his share goes to his children, but if he leaves none, only then to his siblings.”
• As described in yesterday’s post, if your surviving spouse is your beneficiary, your death can be a non-event.
• Neither your beneficiary nor your estate gets hit with income tax solely as a result of your death. Your beneficiary is only taxed when and as he or she takes distributions from the account.
• If your beneficiary is under age 59-1/2, she will not be subjected to a 10% penalty tax because this comes within the “death” exception to the penalty. (The result is different if the beneficiary is the surviving spouse, and she opts for the surviving spouse’s rollover, as described in yesterday’s post.)
• If you made non-deductible contributions to a traditional retirement account, they are not lost as a result of your death. Your beneficiary gets to gradually recover them tax-free just as you would have had you lived long enough, as described in February 15’s post.
• If your tax-favored retirement account is a Roth account (i.e., either a Roth IRA or a Roth 401(k)or Roth 403(b) account), then it is subject to the Roth tax rules, as described in March 4’s post. That means that distributions occurring at least five years after you first made Roth contributions are tax-free to your beneficiaries. (An aside. It’s conceivable that the Required Minimum Distribution rules will require your non-spouse to take a distribution before the five-year Roth clock has run, resulting in a distribution that might be partially subject to tax, as described in March 5’s post. I think Congress messed up on this point.)
• Your retirement account is not immediately depleted by estate taxes as a result of your death. If you are one of the lucky few wealthy enough to generate an estate tax at death, your retirement accounts are thrown in there with all your other wealth in determining that estate tax. But the estate tax is then generally paid by your executor out of your non-retirement account assets; not out of the retirement account itself. So while your retirement account generates an estate tax, it is not necessarily reduced by that estate tax.
• Your beneficiaries can then take distributions in any amount they want, as long as it’s at least the amount required by the post-death RMD rules.
• If your account is in an employer plan, and your beneficiary is not your spouse, he or she is permitted to do a sorta’-rollover into an IRA after your death. The purpose of this sorta’-rollover is to fix the following problem, which used to be all too common. Let’s say you died with a 401(k) account and named your child as beneficiary. The RMD rules (as you’ll see in tomorrow’s post) would permit your child to take distributions over her lifetime; but the 401(k) plan might well require your child to take a lump sum distribution. After all, employers don’t want to be bothered with the administrative burden of accommodating the tax planning needs of former employees’ children. So all potential tax deferral would end at your death. To fix this, the Tax Code now allows the child to roll over such a lump sum distribution into the child’s special purpose sorta’-rollover IRA. Then the child can stretch out distributions from the IRA (and taxation) over her lifetime. Unlike the spouse’s rollover described in yesterday’s post, the child can’t use the joint life expectancy of her and her named beneficiary to determine these RMD’s. Which is why it’s just a sorta’-rollover rather than the full-fledged rollover that a spouse can effectuate.

In tomorrow’s post I will (finally) describe the post-death RMD rules.