The type of retirement fund you have can seriously affect the amount of money your beneficiaries will receive. With certain types, they could lose a lot of money to taxes because of laws about 401(k)s and other plans. Some simple changes to the type of your retirement account can enable your heirs to avoid a tax bomb and receive much more money.
401(k): Traditional vs. Roth
Even though many people have their retirement funds invested in a standard 401(k), it is not the best tool available. Switching to a Roth 401(k)—or adding it to your retirement plan—means that you pay the tax on your contributions instead of your beneficiaries. It may mean making smaller contributions, but it will avoid giving your heirs a tax bomb—and getting far less money.Paying taxes upfront—or at least some of them, if you split accounts—gives more tax-free money to your beneficiaries. As your income grows, taxes will take a larger chunk out of your paycheck. The goal is to pay less in taxes when you are earning less, instead of waiting until you are in a higher tax bracket later in life.
Your Heirs Will Receive More Money
This single change in where you place your retirement savings—or at least some of them–enables your heirs to receive a lot more of your inheritance money. Many employers’ retirement plans permit you to make the change, but some do not offer it. If your employer gives employer-matched contributions, Investopedia says they are made pretax and placed into a standard 401(k).Even though changing from a 401(k) to a Roth 401(k) enables your heirs to receive much more, it can still be a problem if it goes through probate court. You will have to ensure that your named beneficiaries on your Roth 401(k) are up to date.
Contributions to a Roth 401(k)
Contributions to a Roth 401(k) are limited to $20,500 for 2022, if you are under 50. It is increased to $27,000 if you are 50 or older. It is different if you have more than one retirement account with the same employer. In that case, the total allowable contributions are much higher. The Internal Revenue Service says that if you are under 50, your total allowable contributions for 2022—including employer contributions—is $61,000; if older than 50, the total amount is $67,500.Splitting your contributions between a Roth 401(k) and a traditional 401(k)—if your employer offers this option—also has advantages. Although you would pay taxes on your contributions to the Roth 401(k), any money you put into a traditional 401(k) would be post-tax. Splitting contributions reduces your heirs’ taxes considerably when withdrawing the money.
Required Minimum Distributions (RMDs)
A Roth 401(k) requires you to start minimum withdrawals when you reach 72. If you wish to let the money continue to build and not touch it, NerdWallet says that you have the option of rolling it over into a Roth IRA. This kind of account does not have RMDs, and no taxes are required when you make the change. The account manager must make the rollover to avoid taxes.When you split your money between these two types of accounts—a Roth 401(k) and a standard 401(k)—your heirs have fewer taxes to pay each time they withdraw funds from them. If you die with money still in your 401(k), they must take the RMDs and deplete the account within 10 years. Taxes on a standard 401(k) would be considerable because contributions are made pretax. If they are in a higher tax bracket, the government would take a hefty portion of it.
If you are already 72 and decide to switch to a Roth IRA, Fidelity mentions that you still need to take a mandatory RMD for that year. There may be an exception if you are still working after you turn 72, but it may only apply to accounts with your workplace.
The Result of Changing to a Roth 401(k)
Changing to a Roth 401(k) may mean you have less money to put into it because taxes are taken out of your income beforehand. Kiplinger gives an example of the result of making this switch using a couple in their forties and maxing out their contributions with matching employer contributions.The example reveals that after changing to a Roth 401(k), the accumulated taxes on all accounts is cut in half. It is the result of paying taxes before the contributions are made. It also means that taxes on your RMDs are also reduced to half—when you reach 72.
After this couple reaches 65, their pretax savings also falls by half. You fall into a lower income bracket, and you will pay fewer taxes on any employer-sponsored contributions put into a 401(k).
A Potential Problem With Medicare
If your heirs are required to withdraw RMDs within 10 years, it could cause another problem with Medicare. Medicare has brackets for income, and once you enter into a higher income level, your Medicare costs rise. Kiplinger says that once you make between $91,000 and $114,000, the cost of Medicare Part B jumps, from $170.10 (2022 prices) to $238.10. It jumps again between $114,000 to $142,000, where you will pay $340.20, etc. It also rises for Part D.After the Death of the Account Owner
The IRS says that beneficiaries must begin to take RMDs within one year after the retirement account owner dies. It does not matter if they have reached 72 or not.There are some exceptions to this rule. The exceptions are for a surviving spouse, a minor child, someone who is chronically ill or disabled, or someone who is not more than 10 years younger than the account owner.
The Five-Year Waiting Period
A Roth 401(k) owner cannot take RMDs until the account has been open for five years. If you have more than one Roth 401(k) account, each one must be held for five years.An exception occurs when using a direct rollover to combine the accounts. When you do this, the five-year requirement starts from when the first account was opened. If you use an indirect rollover method, the five-year period begins when the Roth account receiving the other one was established.
Good estate planning should consider what happens when your heirs receive your retirement accounts. A tax bomb would greatly disappoint them if their expected money is reduced considerably. A professional estate planner can help you avoid this problem and give more money to your heirs.
The Epoch Times Copyright © 2022 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.
