This isn't so hard to believe anymore. Today's tax-advantaged plans - 401(k)s and some IRAs - are capable of leaving many people millionaires. It would take only $435 in monthly 401(k) contributions and 35 years to make a million dollars. Of course, this assumes 8% monthly compounding, and no one can guarantee that would happen, but the possibilities are there.
The bad news is that U.S. taxes could sink most of this if you're not careful. A $1 million IRA inheritance could be whittled to less than $100,000 almost immediately under a combination of estate and income taxes.
Saving your heirs thousands of tax dollars on your retirement money hinges mostly on decisions you make before you retire. Therefore, it's important to take a look now at how to save heirs tax headaches later on.
Stretch out the tax bill
For the tax conscious, the premise behind retirement plan distributions is simple - the longer you are expected to live, the less the IRS makes you withdraw and pay taxes on each year. Because you can calculate life expectancy several ways and heirs could inherit this payout schedule along with the assets' tax bill, talk to your tax or financial advisor about which ways of calculating life expectancy will give you the longest timeline. There are various other ways to make the tax payments on retirement assets easier for heirs to handle. These are:
1. Selecting a beneficiary - If no one is named, your assets could end up in probate, and your beneficiaries could be taking distributions faster than they expected (which would also happen if your estate becomes the beneficiary). In most cases spouses are preferred because they have several options that aren't available to other beneficiaries, including the marital deduction for the federal estate tax and the ability to transfer 401(k) assets into a rollover IRA.
2. For younger heirs, opening a "stretchout IRA" - If you want to leave your retirement assets to several younger heirs (such as your children), a stretchout IRA lets you split these assets into several accounts, each with its own beneficiary. That way, each beneficiary can recalculate required payments based on their own life expectancies.
3. Being generous - Plan assets given to charity are fully estate-tax deductible, with no income tax owed on the gift.
4. Looking into a Roth IRA - Unlike with traditional IRAs, an heir to Roth IRA assets doesn't owe income taxes on this inheritence, so long as your beneficiary takes at least the minimum distribution when called for. While you're retired, Roth IRAs offer a number of other advantages over traditional IRAs, including potentially tax-free earnings and the ability to put off distributions indefinitely past 70½.
