Protecting Your Loved Ones: Your Online Guide to Sorting Out your Finances Before You Pass Away

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If your loved one has passed away and you are the direct beneficiary of the retirement account like 401(k) or the IRA, you can be the one to control the account by simply presenting the death certificate of the original owner to the bank where the account is held.

While making such adjustments, there is a need to understand the tax implications of inheriting the account. The two types of IRAs you can inherit include the Roth IRA and the traditional IRA.

These are all instrumental if you are looking to sort out your finances before passing away.

 

The Roth IRA

There are a few things to take into consideration when it comes to making decisions regarding a Roth IRA. These include considering the income tax rate of “today” versus the “retirement” tax rate, as well as benefits from the employer.

For a lot of individuals, today’s earnings could place them in a relatively high tax bracket, which is higher as opposed to the tax rate to be paid upon retirement. In such a case, beginning with the Roth may not be recommended, which is especially the case if you are not maxing out your contribution to a plan that deducts contributions from today’s taxable income.

Additionally, if making contributions to a Roth prevents you from leveraging matching contributions from a retirement plan sponsored by an employer, then you are leaving some free on the table.

Therefore, before you can think about making contributions to the Roth IRA, ensure any contributions you make to a plan sponsored by an employer are high enough to take full advantage of the benefit you get.

If you have some funds left over for retirement investment when maxing out your 401(k), then you may go ahead and take advantage of Roth IRA.

Nevertheless, if you lack access to a retirement plan sponsored by an employer, you may be in a better place if you choose the traditional IRA. But again, if you anticipate that the rate of your tax will be higher during retirement, then contributing to the Roth IRA may be your best move.

 

Understanding Roth and Traditional IRA

The Roth IRA was created by the 1997 Taxpayer Relief Act. This is an individual retirement plan which is quite similar to the Traditional IRA in many ways. However, the difference between these two is how the plans are taxed.

Contributions to the Traditional IRA are made with pretax dollars. Usually, you get a tax deduction on contributions made and pay income tax when withdrawing from this account upon retirement. On the other hand, the Roth IRA is funded with the after-tax amounts, and the contributions made are usually not tax deductible.

However, there is a possibility of getting a tax credit of 10 to 50 percent contribution and this will depend on your life situation as well as your income. And when you begin to withdraw funds, the qualified distributions are not taxable.

Deciding whether or not the Roth IRA is more advantageous as opposed to the traditional IRA will depend on your tax bracket, the tax rate expected during retirement, as well as personal preference.

People who anticipate higher taxes during their retirement may find Roth IRAs to be more beneficial because the total amount of tax they will avoid during retirement will be higher compared to the income tax being paid today.

With that in mind, lower-income workers, as well as younger employees, may benefit tremendously from Roth IRA. When you start saving with an IRA from the early stages of your life, you will be in a position to take advantage of compound interest’s snowballing effect.

In that case, the amount you invest, along with its earnings will be reinvested to create additional earnings, which will also be reinvested, and so on.

People who earn higher wages and still expect a lower tax rate during their period of retirement can benefit from the Roth IRA. Simply put, many individuals prefer getting tax-free income during retirement while those who do not require their Roth IRA asset upon retiring may leave their funds to accrue indefinitely so they can be passed to their beneficiaries tax-free when they finally pass away.

While the heir must take distributions from the inherited IRA, they can stretch out their tax deferral by accepting distributions depending on the duration of time they expect to live. Additionally, a spouse may roll over the inherited IRA into a different account and not have to start taking distributions until they reach the age of 70½.

Some individual convert to the Roth IRAs because they anticipate increased in the future tax, and this account makes it possible for them to lock in the existing tax rates on their conversion balances.

The highly compensated workers and the executive of companies who are capable of contributing to the Roth plan through their organizations can also roll their plans into Roth without any tax implication. This approach also allows them to escape having to accept the mandatory minimum distributions after turning 70½.

 

The Traditional IRA

When you inherit the traditional IRA from a spouse, there are three primary options available to you. For the Roth IRA, the rules are different.

#1 Cashing In

There are taxes on inherited IRA whenever you cash it in. However, regardless of age, no penalty taxes will be applicable when it comes to the traditional IRA. This is advantageous because usually, IRA distributions before the age of 59 ½ are subject to the 10 percent penalty tax for early withdrawal.

Nevertheless, even with the penalty taxes off the table, it might not be a prudent move to cash in the IRA. It is important to first consider what your tax bracket is.

Cashing in huge amounts from the IRA will mean a larger percentage of it will go directly to the federal taxes. Additionally, the state income tax will also be applicable. It may be a good idea to simply withdraw the money whenever you require it rather than cashing in everything at once.

 

#2 Treat IRA as Your Own

Another option would be to treat the IRA as your own. This can be made possible by putting the deceased account in your name or by rolling the IRA into your existing IRA account. If your spouse/guardian was older than you, or if you are above the age of 59 ½, you can easily put the deceased IRA account in your name.

It makes it possible for you to delay taking the required minimum distributions as long as possible. When you decide to treat the IRA as your account, the future RMDs will be ascertained based on your age, starting with the period you become the IRA owner.

For a better illustration, here is a good example: You are 65 and your spouse was 72 and started taking his/her RMDs when he/she was 70 ½. You decide to treat the inherited IRA as yours. In such a case, you do not need to take the annual RMDs until you attain 70 ½, irrespective of whether or not your spouse was already doing so. In other words, the clock resets effectively.

One of the advantages of leveraging this option is the continued tax deferral. If you are above 591/2 years of age, you can still make your withdrawals without any penalty tax. However, you are expected not to do this until you attain 70 ½ years.

It is also imperative to note that if you decide to treat the IRA as your own and you haven’t attained 59 ½, your distributions will be subjected to a ten percent penalty tax.

 

#3 Treat Yourself as the Beneficiary

If you are below 59 ½ years of age or older compared to your spouse, this could be your best option when dealing with an inherited IRA. When you set yourself up to be the beneficiary of your spouse’s IRA account as opposed to being the owner, your minimum distributions will be determined by the age of your spouse at the time of their death. As a result, this presents possibilities.

If they passed away after their RMDs started because they were above the age of 70 ½, you need to take distributions based on:

  • Your single life expectancy
  • The life expectancy of your spouse based on their previous RMD schedule

Additionally, if the spouse passed away before their RMD started, you can defer distribution up until the point where their RMDs would have begun. At this point, you can take distributions over the expectancy of your single life.

The good thing about leveraging this option is that it is possible to take withdrawals whenever necessary without any penalty tax if you haven’t reached 59 ½.

Moreover, if you are older compared to your spouse, you could defer RMDs until a point your spouse would have taken them. It is important to note that this would be a date past your own age of 70 ½.

 

In Conclusion

This guide highlights all you need to know regarding the Roth and the traditional IRA. It is important to sign up for these retirement plans for your sake and the sake of your loved ones.

Your loved ones, whether spouse or children can benefit tremendously from the IRA.

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