Updated April 2017 — Discovering a forgotten IRA or 401(k) during retirement planning can be a great feeling. Who wouldn't welcome finding an additional asset? Depending on when you discover that unused retirement account and what your wealth transfer plans are, you may want the option to leave that account to someone else in your estate. But unless you are careful, you may unintentionally create more of a burden than a blessing for your heirs.
"The tax implications of transferring retirement accounts (IRAs, 401(k)s, etc.) can be complicated for those trying to proceed on their own," explains Jeffrey McClean, Senior Wealth Planning Strategist, Wells Fargo Private Bank. "A good rule of thumb is that you don't transfer a retirement account during your lifetime. Instead, it is transferred only upon death."
If you plan to pass down assets from your retirement account to your heirs, here are some key steps to keep in mind, according to McClean and Michele Grant, Director of IRA Products and Strategies for Wells Fargo Advisors.
Step 1: Choose a designated beneficiary. "One of the most frequent estate planning misconceptions is that a will can name the beneficiary for a retirement account. Rather, it is the beneficiary designation that controls the beneficiary of a retirement account, notwithstanding the language in the will," says McClean. You have many options for whom an account can pass to, but McClean counsels that you consider your spouse first. "A surviving spouse is typically seen as the most logical person to inherit an IRA or 401(k)," says McClean, explaining that a spouse can roll over the IRA into his or her own plan and can defer distributions (and income tax) until he or she reaches retirement age.
"If you want to transfer to someone other than a surviving spouse, then another option is to give it to a charitable organization," adds McClean, who explains that leaving IRA assets to charity can not only fulfill a person's charitable intent but also make better use of assets. The charity will receive the assets free of income tax because of the charity's exempt status, so the assets are worth more to the charity than they would be to other beneficiaries.
"Retirement accounts should be considered as a part of your overall estate plan." — Jeffrey McClean, Senior Wealth Planning Strategist, Wells Fargo Private Bank
Shifting 401(k) or IRA assets toward a spouse or a charity may mean you prefer to direct other assets toward children, McClean explains. But you can also direct these retirement savings to your children. "If your intention is for the funds to go directly to your children, then go ahead and name your child or children as your primary beneficiary or beneficiaries," says Grant. "Remember that contingent beneficiaries will only inherit the funds should the primary beneficiary or beneficiaries predecease you."
Step 2: Communicate your intentions to family beneficiaries. By sharing your plans with your children or spouse, you can help them understand what options will be available to them once they inherit the retirement accounts.
Upon the 401(k) or IRA owner's death, Grant explains that, in most cases, the beneficiary will set up an inherited IRA and transfer the assets directly into that account. This could mean a reduced tax burden in the long run. "The children (non-spouse beneficiaries) cannot roll these assets into an IRA in their own name so it is important to establish the inherited IRA," she says.
Step 3: Keep consistent records. "If you're an IRA owner, make sure you have the tax information of recent years available," says Grant. As she explains, you might have assets that aren't going to be taxable to your children, especially if you've made after-tax contributions to a traditional IRA or if you've contributed to a Roth IRA.
And speaking of Roth IRAs, talk to your advisors about converting a traditional IRA into a Roth if your intention is for the funds to go to your children — current tax laws and rates could make this a wise choice.
Step 4: Review, review, review. "Ensuring your wishes for your IRA are carried out can be as simple as sitting down with your financial advisors and signing beneficiary designation forms," says Grant, who adds that any time you have a major life change, you should be reviewing the beneficiaries named on the plan.
Step 5: Look long term and big picture. "The most important thing with any retirement account is to consider the beneficiary designation in conjunction with your wealth transfer plan," says McClean. "Retirement accounts should be considered as a part of your overall estate plan."
While following these steps should help your heirs lessen their tax burden on the assets you leave them, it's wise to remember that Uncle Sam will always be around. "There's no way to avoid income taxes forever," says McClean. "These are tax-advantaged plans that were designed to accumulate until retirement, and when the funds are paid out, there is likely to be an income tax liability."