Protecting IRAs from Unnecessary Taxation

The extraordinary performance of the stock market during the nineties, combined with increasing contributions to retirement plans has led to a growing number individuals with very large IRAs, 401(k) or other qualified accounts. In many households, these accounts may represent the majority of their estate.  When these accounts exceed the Unified Exemption for Estate taxes, which for year 2003 is $1 million, and next year is set to rise to $1.5 million, extra planning may be necessary to protect your estate from unnecessary tax erosion.  Estate taxes can run as high as 49 percent on amounts above the exemption and they are on top of any income taxes that may be due.

Utilizing the Unified Tax Credit properly

Let me demonstrate:

You have an IRA worth $2 million and it represents your entire estate.  If you die this year, you could leave it to your spouse and it would escape both estate taxes and immediate income taxes.  Your spouse could roll it over into his or her own IRA (only a spouse can do a rollover of an inherited IRA).  There is no problem until your spouse dies.  Since the exemption is individual, when your spouse dies (let's assume it happens six months from now, for simplification purposes), their heir now gets the IRA, but only the first $1,000, 000 is protected from estate taxes, that means that taxes are due on $1,000,000. At a 41-percent estate tax rate, $435,000 [i] is due in estate taxes. Unfortunately, since this is the only asset, some of the IRA will need to be liquidated to pay that $435,000, but this money withdrawn from the IRA to pay taxes will be subject to federal income taxes. Your heirs will need to withdraw more than $770,000 from the IRA (not including possible state taxes which will up the ante) to pay all of the taxes due.  Net return to the ultimate heir is $1,230,00. [ii]

This could have been avoided or minimized:

Instead of leaving the entire IRA to your spouse, you could list your spouse as primary beneficiary and an irrevocable trust (sometimes known as a bypass trust) as the contingent beneficiary. Upon your death, your spouse would then disclaim the amount of the exemption ($1,000,000 and rising over the next few years) and that amount would revert to the trust. This must be done within nine months of your death, the sooner the better.  Your spouse would still be able to have an income and access to the principal of the trust (provided you have made those provisions or given the trustee authority to do so).  When your spouse passes, your exemption would be preserved and theirs would come into play and the entire $2 million would bypass estate taxes.

Unnecessary liquidation of an inherited IRA

There is no requirement that an IRA be liquidated upon your death.  In most cases, the beneficiary has up to five years to empty the account, but if the account owner dies before they are required to take Minimum Required Distributions, the beneficiary may be able to adopt a distribution schedule over their lifetime.  For a young person, this could amount to 30 years or more of continuing tax-deferred growth.  Allowing the balance to remain in the IRA could net the recipient considerably more money.

Another point to note here is that if you have multiple beneficiaries with a wide range in age (for example, your children and grandchildren), it may be better to divide your IRA into several accounts, one for each beneficiary.  Otherwise the distribution schedule will be based on the oldest heir, thus shortening the deferral time for the youngest.

Note: The Roth IRA is not currently subject to Minimum Required Distributions (MRD) for the account holder but a beneficiary will need to set up a distribution schedule.

Failing to name a contingent beneficiary

When you die, and your heir dies soon afterward, the IRA becomes part of the estate and must soon be liquidated.  If it passes to a contingent beneficiary, the distribution schedule elected by either you (if you had started MRDs) or your primary beneficiary can continue and allow for additional years of tax-deferral.

For more information on how to protect your IRA from unnecessary taxes, order our free booklet, “IRA Distribution Mistakes and How to Avoid Them,” by clicking here.