Ideally, you’ll live to a ripe old age and be able to provide for your family until your dependents can support themselves. Pinning your family’s long-term financial stability on hopes you won’t die prematurely is a risky strategy, however. Depending on their circumstances, savings and budget, many investors may choose to provide for their families with life insurance, a Roth IRA or a combination of the two.
Roth IRAs and Beneficiaries
The account of a Roth IRA with a designated beneficiary doesn’t pass through probate after the account holder dies. It becomes the property of the beneficiary. If the account holder doesn’t name a beneficiary, or names his estate, the Roth is liquidated and becomes part of the estate. From that point, it’s divvied up according to its owner’s will or probate courts. A Roth is intended to help fund retirement, but its owner may access its funds at any time for any reason. If he hasn’t reached the age of 59 1/2 or he hasn't held the account for at least five years, the Internal Revenue Service assesses a 10 percent early distribution penalty.
Life Insurance and Beneficiaries
Life insurance is a much more straightforward situation for beneficiaries. The purpose of a life insurance policy is to ensure that when the policyholder dies the beneficiaries' financial needs will be met. The policyholder pays a monthly premium. When he dies, his beneficiaries receive the payoff. The benefit goes straight to the named beneficiaries and not through probate. If the policyholder changes his mind or determines his beneficiaries will be able to make ends meet without his income, he may cash out his policy in some cases, and receive his premiums and a chunk of the interest they earned while the insurance company held them.
Taxes and Inherited Roths
The beneficiary of a Roth has a few options when she inherits it, and must choose one by the end of the year after she receives the Roth. She may cash it out and take the money. If the account was opened at least five years before, she’ll get the money tax-free. If not, it’s taxed as income in many cases. Alternatively, she may choose to keep most of the money in the Roth and receive required minimum distributions each year. In most cases, she gets these payments free of taxes, while the balance that remains in the Roth continues to grow free of income taxes. Lastly, if the beneficiary was the spouse of the Roth’s owner, she may opt to roll the cash into her own Roth, or merely keep her husband’s Roth as if it’s her own.
Taxes and Life Insurance Benefits
Although the beneficiary of a life insurance policy receives the payout free of federal income taxes, if you own the policy the IRS treats its benefits as part of your estate. For many policyholders, this is a moot point. If your estate is valued at more than $5.12 million, including the value of the policy, the value of the policy will be added to the value of your estate, and become subject to estate tax. From the beneficiary’s point of view, the money avoids taxation, but the benefit may be indirectly taxed as part of your estate.
- IRS: Publication 590, Chapter 2 - Roth IRAs
- CNN Money: Chosing the Right Life Insurance
- Smart Money: How to Avoid Taxes on LIfe and Disability Insurance
- Smart Money: Inheriting Uncle Henry's IRA
- Forbes: Five Rules for Inherited IRAs
- Nolo: Using Roth IRAs to Avoid Probate
- Amp Insure: What If You Want to Surrender Your Life Insurance Policy?
- Forbes: More Estate Tax Changes Could Follow Fiscal Cliff Deal
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