Sally, a successful small-business owner, knows how to stretch a dollar. Her clients and four employees value her financial acumen, and she brings the same keen discretion to her personal finances. Thirty years ago, Sally inherited what was left in her father’s IRA and by limiting her withdrawals to the minimum required distributions (MRD) she has been “stretching” his legacy ever since — it’s nice to have a cushion for unexpected expenses. She wants to give her son, a budding entrepreneur, the same advantages, but Congress is threatening to curtail the stretch to five years — a move that will deliver a massive tax blow to inherited IRA owners, and a tax bonanza for the government.
How would you protect your legacy?
First, the basic tax rules pertaining to retirement plans and IRAs:
- You are not required to pay taxes on the earnings until you withdraw money from the account. The ability to defer taxes is a powerful wealth-building tool.
- At age 70 ½, you must begin taking MRDs and pay taxes on the amount that you withdraw. If you leave your IRA directly to your spouse, he or she can continue to defer income taxes as well.
- A non-spouse beneficiary must pay taxes on distributions, but by taking only the minimum required distributions your heirs can stretch your IRA for a long time — the difference could mean hundreds of thousands or even millions of dollars to them over the course of their lifetimes.
Unfortunately, since 2012, Congress has attempted to pass legislation that changes the IRA distribution rules. And if they succeed, your children and grandchildren will pay the price.
The good news is that there are workarounds for the workarounds that will go into effect once the legislation does pass.
- Consider Roth IRA conversions and avoid massive and accelerated taxation on inherited IRAs by reducing the amount of assets held in traditional IRAs altogether. Roth IRAs grow and are distributed tax-free. Parents who convert their IRAs into Roth IRAs limit the amount of taxable funds that are passed on to their children. A child who inherits a $1 million Roth will still have to take MRDs and if the law passes, liquidate the Roth within five years of the death of their parent. However, the taxes are already paid on the Roth, so there will be no income tax bill to contend with.
- You can set up a Charitable Remainder Unitrust (or CRUT) and name it as the beneficiary (if you are single) or contingent beneficiary (if you are married) of your IRA. When you die, all of the money goes in to the trust, and is not taxed until it is withdrawn. You can designate an income beneficiary, generally your child or children, who would get an income of at least five percent from the trust for the rest their lives. The distributions are taxable, but will be spread out over a greater length of time than five years. Depending on your child’s tax bracket, the distributions are often taxed at a lower rate than if the entire IRA had to be taxed over five years. When your child dies, or the trust is terminated, the remaining assets are distributed to charity. There are no taxes on your IRA at the time of your death, because the ultimate beneficiary is a charity. And your estate can take a tax deduction in the year that your IRA is transferred to the trust. In many scenarios, if the child lives beyond age 72, he will be better off than if you had left him the money outright. One caveat, this strategy should not be implemented until the new law passes.
- A Survivorship life insurance policy is another way to make up for the accelerated taxation on the IRA. This type of policy is taken out on two people (usually a married couple) and provides benefits to their heirs after the second spouse dies. In many instances, it makes sense to pay for the insurance by withdrawing money from the IRA. This decreases its value, which reduces both estate and income tax liabilities. And the death benefit of the life insurance is paid to your beneficiaries tax-free. This strategy works well even if the proposed law doesn’t pass and can be worth millions of extra dollars to the children if the proposed law does pass.
For many people, their IRAs or retirement assets make up the bulk of their wealth. It really doesn’t seem fair to force accelerated tax payments on your heirs, and significantly reduce the size of their inheritance over the long term. But if you are not paying attention, your heirs could end up paying taxes early. Life insurance, Roth IRAs, and CRUTS, or preferably some combination of them, can significantly add to your legacy. Take a lesson from Sally and consult with your financial advisor to review your options and take steps to protect the next generation. –James Lange is a CPA/attorney whose specialty is estate planning for clients with significant IRAs and retirement plans. He is the best-selling author of Retire Secure! and recently published The Little Black Book of Social Security Secrets. You can sign up for Jim’s books for free at: www.paytaxeslater.com.