Inherited Retirement Plans: The Value of a Stretch Option

Individual Retirement Accounts (IRAs) and 401(k) plans are key components in most people’s retirement planning, and each provides important tax advantages. Unfortunately, any assets that pass to your children or other beneficiaries at your death are subject to taxes that can severely reduce their value. Advanced planning with a knowledgeable financial advisor can help minimize the tax impact.

At death, distribution of retirement plan proceeds to a beneficiary results in sobering tax consequences: every dollar received from a traditional retirement plan is subject to ordinary income tax. If a child-beneficiary inherits a $500,000 traditional 401(k) account from a parent, for example, and accepts "lump sum" distributions, income taxes can immediately reduce the total value by as much as 33%. Moreover, if estate taxes are applied to the inheritance, its value could be reduced by 50% or more.

If your retirement plan doesn’t offer a stretch option, there are other strategies that can mitigate the negative tax consequences associated with a lump-sum distribution.

With a "stretch option," the child or beneficiary can elect to receive minimum distributions over his or her lifetime. This option defers payment of the income tax on amounts yet to be received. Most important, the principal remaining inside the inherited retirement account continues to enjoy tax-deferred growth over the child’s IRS-determined life expectancy. As the child grows older, the minimum distributions from the inherited retirement account will increase in size and possibly provide the child with a lifetime of extra income.

How can you ensure this type of growth for your retirement plan proceeds?

  • Contact your BB&T financial advisor. Together you can review the beneficiary designations for each of your retirement accounts to make sure they represent your best interests. If one or more do not, fill out a new beneficiary form to make the required changes.
  • Update your beneficiary designation—this is absolutely critical. If a parent dies before the age of 70½ with no designated beneficiary on his or her retirement plan, or if the beneficiary is "my estate," the five-year or lump sum distribution will be the only options available to the estate. Worse yet, the plan will be unnecessarily subjected to probate.

Unfortunately, not all plans have a stretch option available. In some cases, employers do not want to manage the retirement account assets after an employee’s death. If your plan doesn’t offer a stretch option, there are other strategies that can mitigate the negative tax consequences associated with a lump-sum distribution.

  • Consider a Transfer to a Traditional IRA. If the stretch option is important to you, your BB&T financial advisor may be able to facilitate a tax-free transfer from the employer-sponsored retirement plan to a stretch-friendly Traditional IRA.
  • Create a trust designed for inherited retirement plans. There are many reasons to leave your retirement plan assets in trust rather than leaving them to a beneficiary, especially a non-spouse beneficiary. You may want to protect the benefits from creditors and estate taxes, provide control over their distribution to a named minor beneficiary by a responsible trustee, and codify multi-generational planning features. Equally important, a properly structured trust provides greater assurance of long-term growth and tax deferral over the life expectancy of each beneficiary.

An often-quoted commercial message states, "You can pay me now or pay me later." If your retirement accounts allow for it, paying the IRS later, over extended, stretched-out periods rather than now can lead to more rewarding wealth accumulation and distribution outcomes for you and your family.

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With careful advance planning and assistance from a knowledgeable financial advisor, you can meet your retirement goals and reduce the impact of taxes on the benefits you want to leave your beneficiaries.

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