Life Insurance Is a Good Estate Planning Tool but Needs to Be Done Carefully

With proper planning and the help of a seasoned estate planning or probate attorney, insurance money can pay expenses, like estate tax and avoid the need to liquidate other assets, says FEDweek’s recent article entitled “Errors to Avoid in Using Life Insurance for Estate Planning.”

As an example, let’s say that Reggie passes away and leaves a large estate to his daughter Veronica. There’s a big estate tax that’s due. However, the majority of Reggie’s assets are tied up in real estate and an IRA. In light of this, Veronica might not want to proceed directly into a forced sale of the real estate. However, if she taps the inherited IRA to raise cash, she’ll be required to pay income tax on the withdrawal and forfeit a very worthwhile opportunity for extended tax deferral.

If Reggie plans ahead, he could purchase insurance on his own life. The proceeds could be used to pay the estate tax bill. As a result, Veronica can retain the real estate, while taking only minimum required distributions (RMDs) from the inherited IRA.

If the insurance policy is owned by Veronica or by a trust, the proceeds probably won’t be included in Reggie’s estate and won’t increase her estate taxes.

Along these same lines, here are some common life insurance errors to avoid:

Designating your estate as beneficiary. When you make this move, it puts the insurance policy proceeds into your estate, exposing it to estate tax and your creditors. Your executor will also have to deal with more paperwork, if your estate is the beneficiary. Instead, name the appropriate people or charities.

Designating just a single beneficiary. You should name at least two “backup” beneficiaries. This will decrease any confusion, if the primary beneficiary predeceases you.

Throwing the copy of your life insurance policy in the “file and forget” drawer. You should review your policies at least once every few years. If the beneficiary is an ex-spouse or someone who’s passed away, make the appropriate changes and get a confirmation from the insurance company in writing.

Failing to carry adequate insurance. If you have a youngster, it undoubtedly requires hundreds of thousands of dollars to pay all her expenses, such as college bills, in the event of your untimely death.

Talk to a qualified and experienced estate planning attorney about the particulars of your situation.

Reference: FEDweek (Dec. 12, 2019) “Errors to Avoid in Using Life Insurance for Estate Planning”

I’ve Inherited an IRA – Now, What about Taxes?

Inheriting an IRA comes with several constraints. As a result, it can be tricky to navigate. You are at an intersection of tax planning, financial planning and estate planning, says Bankrate’s article “7 inherited IRA rules all beneficiaries must know.” There are a number of choices for you to make, depending upon your situation. How can you figure out what to do?

Whatever your situation, do NOT cash out the IRA, or roll it into a non-IRA account. Doing this could make the entire IRA taxable as regular income. Do nothing until you have the right advisors in place. For most people, the best step is to find an estate planning attorney who is experienced with inherited IRAs.

Here’s what you need to know:

The rules are different for spouses. A spouse heir of an IRA can do one of three things:

  • Name himself as the owner and treat the IRA as if it was theirs;
  • Treat the IRA as if it was his, by rolling it into another IRA or a qualified employer plan, including 403(b) plans;
  • Treat himself as the beneficiary of the plan.

Each of these actions may create additional choices for the spousal heir. For example, if a spouse inherits the IRA and treats it as his own, he may have to start taking required minimum distributions, depending on his age.

“Stretch” or choose the 5-year rule. Non-spouse heirs have two options:

  • Take distributions over their life expectancy, known as the “stretch” option, which leaves the funds in the IRA for as long as possible, or
  • Liquidate the entire account within five years of the original owner’s death. That comes with a hefty tax burden.

Congress is considering legislation that may eliminate the stretch option, but the proposed law has not been passed as of this writing. The stretch option is the golden ticket for heirs, letting the IRA grow for years without being liquidated and having to pay taxes. If the IRA is a Roth IRA, taxes were paid before the money went into the account.

Non-spouse beneficiaries need to act promptly, if they want to take the stretch option. There is a cutoff date for taking the first withdrawal, depending upon whether the original account owner was over or under 70 ½ years old.

There are year-of-death distribution requirements. If the original owner has taken his or her RMD in the year that they died, the beneficiary needs to make sure the minimum distribution has been taken.

There might be a tax break. For estates subject to the federal estate tax, inheritors of an IRA may get an income-tax deduction for the estate taxes paid on the account. The taxable income earned (but not received by the deceased individual) is “income in respect of a decedent.”

Make sure the beneficiary forms are properly filled out. This is for the IRA owners. If a form is incomplete, doesn’t name a beneficiary or is not on record with the custodian, the beneficiary may be stuck with no option but the five-year distribution of the IRA.

A poorly drafted trust can sink the IRA. If a trust is listed as a primary beneficiary of an IRA, it must be done correctly. If not, some custodians won’t be able to determine who the qualified beneficiaries are, in which case the IRS’s accelerated distribution rules for IRAs will be required. Work with an estate planning attorney who is experienced with the rules for leaving IRAs to trusts.

Reference: Bankrate (Nov. 19, 2019) “7 inherited IRA rules all beneficiaries must know.”

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)”

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