With trillions upon trillions of dollars locked away in tax-deferred accounts like traditional IRAs and 401(k)s, should come as no surprise that the largest asset you own is probably your retirement account. For decades you've saved religiously for your retirement but there’s one thing missing; you have yet to pay any taxes on the money you've saved. Hidden deep in your well-planned retirement plan is a potentially huge hidden and expensive mistake that may cost your family hundreds of thousands of dollars.
I once read that the average time it takes your beneficiaries to cash in your IRA is—drum roll please—93 days. The largest asset you own, something it’s taken you decades and decades to save, can literally be slashed by income taxes by 40 percent because of a lack of or incomplete estate planning. Let me give you a worst-case example:
Say you have a $450,000 IRA and your primary beneficiary is your spouse. Under IRS publication 590 (the bible for IRAs), spouses have virtually unlimited options when they inherit an IRA. The real, hidden problem is when your IRA goes to a non-spouse beneficiary such as your children or anyone else you’re not married to. Non-spouse beneficiaries of IRAs are treated very differently than spouses and if they choose to receive your IRA in a lump sum fashion, almost half of what you've saved may go to the government through one of the largest confiscations of wealth possible.
Your $450,000 IRA, if inherited incorrectly by your children (or anyone other than your spouse) is subject to ordinary income taxes, which at the currently “low tax rates” would equal about 40 percent between federal and state income taxes. This means that $180,000 would be lost to federal and state governments. You could have the best investment approach ever designed, but without the right distribution strategy the government potentially becomes the biggest benefactor. So, if you've accumulated a significant amount of wealth in your tax-deferred retirement accounts here are three critical factors you must be aware of to set your IRAs or 401(k) up as a lasting legacy:
- Backup beneficiaries. The biggest mistake we see day in and day out when meeting with prospective clients is the lack of correctly designated beneficiaries. The easiest and best thing you can do is to verify that you have a primary and contingent beneficiaries listed on all of your retirement accounts. It’s not enough to list generic beneficiaries like “my living spouse” as primary and “my living children” as contingent beneficiaries. To potentially prevent a huge tax bomb from decimating your life-savings you must specify the names, dates of birth, Social Security numbers, etc. of your beneficiaries. There is a difference between named beneficiaries and designated beneficiaries.
- Prudent investment strategies. Even the best-laid investment plan can fail and one of the most common mistakes is taking an unhealthy level of risk with your retirement accounts. If you’re expecting your IRA to last the rest of your life and beyond it is critically important to control risk. If you lose 50 percent because of a market crash, your legacy may not last as long as you had intended. Control risk with IRAs with a conservatively tilted investment strategy. After all, if you lose money in an IRA you receive no tax deduction unlike in a non-IRA account.
- Correct custodial and trust documents. Many retirement savers are unaware of the hidden dangers in IRA custodian documents or trust arrangements. They sign these important documents without fully understanding the consequences. Dust off your IRA custodian document and double-check the fine print to verify that your beneficiaries are not able to receive their IRA inheritance in a lump sum fashion and pay a huge tax bill. If you have a living trust things get a little hairier because very few trusts are designed to avoid the tax bite on an IRA inheritance. If you've saved a lot of money in your retirement accounts and you want to make sure that it lasts as long as you do.
Robert Russell is the author of Retirement Held Hostage, CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to The Wall Street Journal, SmartMoney, & FOX Business.