When planning for retirement, you may pass along some or all of your assets that are unused during your lifetime. This is accomplished through a death benefit provision on your retirement accounts as well as any insurance policies. Death benefits allow your spouse and children to use your money for any purpose they want, and in some cases you may specify how the benefit is received.
There are many different kinds of death benefits that can be passed on to your heirs. You may choose to leave your family money through a life insurance policy, a retirement account or through an annuity.
A life insurance policy is a contract that pays a fixed amount of money to a beneficiary you name in the policy. The policy pays a benefit when you die. The benefit is normally many multiples of the amount of money you've paid into the policy. A retirement account, like a 401k plan or IRA, allows you to pass on any money you haven't used for retirement income by naming a beneficiary on the account prior to your death. An annuity is an insurance policy that guarantees and income to you during retirement. This guarantee may be deferred, which is called a deferred annuity. A deferred annuity functions like a long-term savings account with an insurance company. The death benefit of the annuity is whatever is in the annuity's account.
All of these death benefits have different tax rules that need to be adhered to or your beneficiaries will be subject to penalties for unpaid taxes. Life insurance death benefits are tax-free. Retirement account benefits are fully taxable at income tax rates if the account is a traditional account (traditional IRA or 401k plan) and are tax-free if the account is a Roth account (Roth IRA or 401k plan). Annuities are only taxed at ordinary income tax rates on the investment gains in the contract.
By leaving your family a death benefit, your family is able to pay off any debts you may have left behind. But your family may also need that money to replace an income that you were contributing to the household. The money could also be used to help fund your spouse's retirement since she won't have your income to depend on anymore. Whatever the reason, the death benefit you leave to your heirs can help them relieve the financial stress of your death.
When considering what kind of death benefit to leave to your family, consider what your family would need the money for. Only two types of death benefit provide tax-free benefits. A life insurance policy ensures that your family receives everything you intend for them to have. More than that, it provides money that you haven't been able to save up yet on your own. Your other option, to maximize the benefit to your loved ones, is to leave them a Roth account since Roth accounts won't be subject to taxation.
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