Qualified investments are also known as retirement accounts, and they have tax advantages when the money is deposited into the account. Usually, the advantage is deferring the taxes. IRA or a 401(k), 403(b), 457, TSP are all examples of qualified funds or qualified retirement accounts.
What that means is you put the money into the account before you pay taxes on it, then you don’t have to pay taxes on it in that income year. That doesn’t mean it remains untaxed forever; someone will have to pay the taxes on it eventually. Hopefully, it’s you, but if something were to happen to you then it would be the beneficiary of your account, your spouse, or children.
Beneficiaries of Retirement Accounts
There’s one big mistake that many people make in their estate plan with regards to their retirement accounts. On these accounts, you’ll list a “Pay on Death” beneficiary (POD) that states to whom the money will go if you die. It is pivotal that you list an individual as your POD beneficiary. Listing your estate is a huge mistake.
People get a bit of a tax break as a beneficiary of a retirement account.
If it’s a spouse, they can take this money out very slowly over their life, only being taxed on the amount they withdraw and only at their marginal tax rate at the time of withdrawal. This means they get to spread out the tax burden and make the overall tax amount lower.
If it’s your adult children, they can withdraw the money over a ten year period. This isn’t as good as over a lifetime, the taxes will be higher over that condensed time frame, but it’s still better than withdrawing and being taxed all at once. They can plan how much tax they want to pay. If they’re higher income, they might choose to take some more in certain years when they know their marginal tax rate will be lower.
If you name your estate though, the whole thing has to be pulled out in five years. All the money in the account will be paid out to the estate, and the estate is going to have to file a tax return claiming that income. The estate will then have to claim all the people in the estate who get this money – and those people are going to have to claim that on their taxes, whether they like it or not.
There are no options and no flexibility. The estate has to stay open during this five-year period and everyone involved will have to pay taxes on it at that time.
It’s an expensive disaster for your family. Make sure that doesn’t happen to them by ensuring a professional look over your estate documentation.