What happens when someone dies?

This question has come up recently, and it’s an important one.  On the one hand, there are important options you may have if you become an inheritor or an executor for the estate of a loved one.  On the other hand, there are simple things that you can do to ensure that your money goes where you want it to go after you are gone.  Neither are as complicated as you may think.

I am only going to comment here about tax-deferred accounts (traditional IRA’s and 403b’s, for example).  Taxable accounts (ie, bank accounts) and tax-free accounts (ie, Roth IRA’s) would be slightly different; and inherited items like property would follow a completely different set of rules and a different line of thinking.  For that, you should consult an experienced estate planning attorney.

Misconception #1 – If I inherit an account, I have to take out the money.

There are a lot of misconceptions about what happens to a tax-deferred account when the account owner passes away.  The most common that I see is that the inheritors don’t realize they have options.  Many inheritors think they have to take a lump sum, which is not true.  Rules can vary by company (or tax type), but usually you can decide whether you want to take a lump sum, or stretch out the payments over a number of years.  How do you decide?  One big item to consider is taxes.

Distributions that come out of tax-deferred accounts (most IRA’s and 403b’s, for example) are taxable to the inheritor, so that’s something to be aware of when deciding whether or not to take a lump sum distribution.  Consider how the “tax bite” will affect your inheritance.  Very often it can be to the inheritor’s benefit to defer taking the money as long as possible, spreading it out over time.  That way, you defer the tax liability as well as giving the investments time to potentially grow.

The powerful Stretch IRA

A powerful gift that inheritors often miss out on is the opportunity to create a “stretch IRA” from the inherited account.  This means the inheritor rolls the inherited money into an IRA in their name.  The account is still tax-deferred until distributed.  Each year the inheritor has to take out a required minimum amount (usually this is small), based on their life expectancy and the amount in the account.  The rest of the account continues to grow over their lifetime, potentially resulting in a “gift that keeps on giving” over a long period of time.

This “stretch” option is not available from every company or every type of account, so be sure to ask about it if you are an inheritor.

Misconception #2 – The Executor of an estate has to be a family member.

Another common misconception I hear is the assumption that the Executor of the estate must be a family member.  This is not true; an account owner may name practically anybody as their executor, from a friend to a disinterested third party like an attorney or a banker.  Sometimes people like to use a third party because it helps to have a neutral person in charge of distributing the estate, to help alleviate any perception of partiality.  This would be a decision made by the account owner and specified in the estate planning documents (drafted by an estate planning attorney).

Misconception #3 – Assuming that the Will says where everything goes.

Having said that, however, I must make a special note about the third misconception I come across: tax deferred accounts like IRA’s and 403b’s are ruled by the beneficiary form, not by the account owner’s will.  The beneficiary forms are, in fact, called “will substitutes” because they supersede a will.  This is really important for you to know, so you keep your beneficiary forms up to date on these types of accounts.  The most common error you hear about is someone who has divorced, but forgot to take the divorced spouse off the beneficiary form.  If the form is not updated, the money will go to the person listed on the form, whether they are divorced or not.  If you’re not sure who your beneficiaries are, contact your investment company.  It should be a simple matter of minutes to update your beneficiary forms, though it will require at least a signature.

Misconception #4 – Keeping your estate plans a secret.

Lastly, I want to make the observation that the families who are most successful during this time of transition are those who have talked about this subject together.  Even if the inheritors do not always know all the details, if they are aware that there are account out there, and they know who to contact, they are much more prepared and comfortable as they move forward.

Overall, the process of transferring tax deferred accounts is usually fairly straightforward, and often not as “scary” as inheritors think.  As a financial planner, I am honored when I can help a family in navigating the questions that arise when an account is inherited.  Just a few pieces of important information can make a huge difference to families in years to come.

Shadowridge Asset Management, LLC does not offer tax planning or legal services, but may provide references to accounting, tax services or legal providers.  They may also work with your attorney or independent tax or legal advisor.