Is Your Nest Egg a Tax Trap?
Every year Americans contribute to IRAs, 401k plans, and other retirement plans, building resources that help them secure a comfortable retirement. And, thanks to careful, diligent saving, many families are waking up to an attractive nest egg in their retirement years.
Statistics indicate that most people take only minimum withdrawals from their IRAs for a number of years after age 70 1/2. As a result, many retirement fund balances do not diminish until retirees are well into their eighties, if at all. This means that retirement accounts are often a substantial portion of the estate at death.
The most common way retirement funds are transferred is by naming a child as the beneficiary of the retirement plan. And while this seems on the surface to provide children with a nice inheritance, transferring retirement funds in this manner can result in the highest levels of taxation, dramatically shrinking the actual amount realized by family.
For example, a $1 million dollar IRA could be subject to federal estate tax, state inheritance tax, and federal and state income tax. The net result of this taxation can easily approach 60% . . . leaving only 40% for the children . . . or $400,000 of the original $1 million plan.
Retirement accounts are excellent tools for amassing funds, but make poor inheritance plans. However, there is good news. Some careful planning can result in minimum tax and maximum returns.
This report discusses the pitfalls that both IRA owners and beneficiaries can fall into, and the techniques to avoid them. Please note – the planning techniques described in this report are not all applicable to Roth IRAs. Consult your tax or legal advisor for advice regarding your specific situation.
A Typical Estate
Let’s take a look at the Estate of Mary Smith. Mary has a typical estate of $500,000 which includes a $50,000 IRA. Mary has been a faithful supporter of a charity and desires to leave a tenth of the estate to that charity.
The typical plan is to allow the children to receive the IRA under the IRA beneficiary designation and to transfer $50,000 by will from the remaining assets to the charity. Since the estate assets generally include a home, perhaps stocks and bonds, cash and CDs and land, the assets given to charity would come from the type of assets that could be given to family with no income taxation to the family. That is, assets that enjoy a “step-up” in basis.
However, IRAs do not receive a “stepped-up” basis. The recipient will pay income tax on the entire amount of IRA assets when they are distributed. The chart illustrates that the IRA passed to the children has shrunk by $15,000, or 30%. Larger estates that exceed estate tax limits will experience more significant tax impact. The important point to keep in mind from this simple illustration is that even the smallest estates will experience a tax impact if the distribution of retirement assets is not handled carefully.
| Total Estate | Children | Charity | IRS | |
| IRA | $ 50,000 | $ 35,000 | -0- | $ 15,000 |
| Other assets | $450,000 | $400,000 | $ 50,000 | -0- |
Continue for “A Better Solution”….
A Better Solution Suppose Mary took a careful look at how her assets would be treated after death. A better solution is to give the IRA to charity and the other assets to children.
Viewed from the standpoint of children, an estate consists of both “good” and “bad” assets. The home, land, stock, bonds and CDs are all “good” assets that can be received by children with no payment of income or capital gains tax. If Mary chooses to give the IRA to charity, the good news is that, in the hands of a charity, this “bad” asset becomes a “good” asset.
The charity is tax- exempt and does not have to pay income tax. The only loser in this scenario is the IRS, which collects no taxes.
| Total Estate | Children | Charity | IRS | |
| IRA | $ 50,000 | $ 50,000 | -0- | |
| Other Assets | $450,000 | $450,000 | -0- | -0- |
Next: Learn about how to simplify by making good beneficiary choices…..
Beneficiary Choices
In years past, it was difficult to change beneficiaries. New rules now allow you to change your beneficiary with no difference in your annual distribution. You may now change your beneficiaries as often as you would prefer to do so, and also name a charity as a beneficiary.
There are six basic choices for designated beneficiaries. You may select:
1. A surviving spouse who rolls over the IRA into their own IRA account.
2. A surviving spouse who will simply take distributions under the correct schedule from your IRA.
3. A child, grandchild, nephew, niece or other family member as designated beneficiary.
4. A class of beneficiaries. For example, you may choose all of your children or all of your grandchildren who are living when you pass away. This class designation allows for the possibility that children or grandchildren would be born or adopted. However, there may be a slight tax benefit to them if they are named separately.
5. A trust as a beneficiary. The trust could be specifically designed to provide distributions to your children or other family members.
6. A charity as beneficiary for part or all of the IRA. The good news is that selecting a charity will not affect the distribution amounts to you.
Multiple IRAs
Some individuals desire to benefit two or three different members of their family, charities or trusts. For example, it is possible to have a transfer outright to children, a transfer to a qualified exempt charity and a transfer to a Trust. A simple way to control the levels of distribution is to set up several IRAs and then transfer each IRA to the appropriate beneficiary. 
While there are minimum distribution requirements for IRAs, the good news is that the distribution may be selected as desired from any of the available IRAs. In this manner, you may control distributions and insure that the appropriate parties are benefited as you desire.
How to Receive an Inherited IRA
Here’s a helpful word of caution to beneficiaries regarding the proper way to receive an inherited IRA. Beneficiaries will often change the title of an inherited IRA to remove the name of a deceased parent. This seemingly simple change can have disastrous tax consequences.
The re-titling of an inherited IRA is a critical process that is all too often poorly handled by IRA custodians. A careless IRA custodian may simply issue a check to the beneficiary, without advising them of other payout options, such as the life expectancy (“stretch”) payout.
Since the beneficiary (unless he or she is the surviving spouse of the decedent) cannot roll over that distribution, the distribution is immediately taxable and the possibility of a stretch-out over the beneficiary’s life expectancy is lost.
Worse, the IRA custodian may transfer the money to a new IRA in the beneficiary’s name, thus causing a taxable distribution followed by an excess IRA contribution. If you make an excess contribution and fail to correct it you’re required to pay a 6% penalty tax each year the excess contribution remains uncorrected.
The careful IRA custodian often has an entirely separate form of account agreement for an inherited IRA (preferably on a different color paper), which explains the beneficiary’s rights, and is clearly titled as an inherited IRA. The beneficiary signs the inherited IRA agreement, and thus becomes the owner of the decedent’s account without taking a taxable distribution.
The instructions for IRS Form 5498 (the form an IRA custodian must file annually to notify the IRS of the IRA’s value) suggests titling the account in the following format: “Brian Willow as beneficiary of Joan Maple” or something similar that signifies that the IRA was once owned by the decedent.
“Stretching Out” an IRA
A commonly accepted principle in estate planning is that distributions from a retirement plan should be deferred as long a possible. Deferral over the lifetime of the designated beneficiary often allows the account assets to continue to grow and generate distributions over a longer period of time.
If a beneficiary receives an IRA outright, it is possible for them to take a stretch distribution. However, in many cases, beneficiaries do not follow the minimum withdrawal schedule. Rather, they take larger withdrawals or sometimes the entire IRA and simply pay the tax up front. This greatly increases their income tax and diminishes the potential value of what could have been received.
Next Steps
Personal and family objectives should determine how you plan for the distribution of your retirement plan funds. Different options can help meet individual objectives; however, careful consideration of the tax implications, along with some expert advice from a planning professional, can help insure that the nest egg you’ve worked so hard to put together doesn’t fall prey to the externals that can greatly diminish its value.
Village Missions cooperates with planning professionals and community foundations throughout the United States. We welcome the opportunity to introduce you to these resources and help you establish a plan which best meets your goals.
Contact us: Jim Cross, CPA Chief Financial Officer (800) 617-9905 x 120
