Who Inherits IRAs

Who Will Inherit Your IRAs? Uncle Sam? - 2/04/08

INTRO: You want your children and grandchildren to inherit your hard-earned money, not your Uncle Sam.

1. MANY PEOPLE, LOTS OF OUR VIEWERS, HAVE A SIGNIFICANT PORTION OF THEIR ASSETS IN RETIREMENT ACCOUNTS, LIKE IRAS AND 401(K)S. THAT'S GOOD, RIGHT?

A. Yes. The IRS has given these retirement accounts special tax-deferred status, but they are waiting in the wings just waiting to tax the money in these accounts. As these funds are withdrawn from the tax-deferred accounts, it becomes taxable as ordinary income. The years of avoiding the tax deferral will come to an end.

2. WHEN IS THE MONEY IN THESE ACCOUNTS WITHDRAWN AND TAXED?

A. The money in these accounts will be distributed generally when three events occur. First, the account owner (and there can only be one owner, no joint owners) may withdraw money for the account as needed to supplement their retirement income. If done after age 59 2, it is taxed as ordinary income. Prior to age 59-1/2. the withdrawals are taxed as ordinary income, and there is a 10% penalty. There are ways to avoid the penalty like disability or hardship but we will save that for a later discussion.

B. The second way money comes out is through Required Minimum Distributions; federal law requires that you must start taking distributions once you reach 70 2. Whether you like it or not, at this age the funds in your IRA or 401(k) need to start coming out, and are taxable as ordinary income. Happy 70th birthday from the IRS! Make certain you understand how to calculate and when to take your RMDs, because the penalty for taking the improper amount is 50%.

3. WHAT IS THE THIRD TIME FOR DISTRIBUTION?

A. Now the third way the money in your IRA comes out is when you pass away. This is where it is very important that the necessary steps have been taken so that the IRS doesn't get TOO BIG a share of the balance in your retirement accounts TOO SOON. If you have not been pro-active in the administration of your retirement account, when you pass away your heirs will also be attending the funeral of your retirement accounts. And the IRS will also be attending the funeral because at the untimely end of your retirement accounts the IRS could stand to walk away with a significant portion of the account.

B. If your plans are to spend all of the money in your retirement accounts while you are alive, this planning is of little importance to you. But if your overall plan includes passing as much of your accumulated wealth to your family with a minimal tax impact, planning is of utmost importance.

C.IRAs or any other type of tax-deferred investment can be subject to both income taxes and estate taxes at death. (We are talking about income taxes at this point. Estate taxes are beyond the scope of this conversation, but let's concentrate on the income tax side.) Many people have had their eyes focused on how much they can accumulate in their retirement accounts, but have failed to take the proper steps to make sure this accumulation passes on to their families with the minimum amount of taxes. Caution needs to be taken in setting up the accounts, and then reviewing them to take advantage of the tax rules regarding the distributions from these accounts.

D.By putting a plan in place that takes advantage of the current tax laws, the amount that will end up going to the government in relation to the amount that will be left for the family can be reduced significantly. The key to this planning process lies with how the beneficiaries on the retirement account are set up, and how the funds in the account are transferred to the beneficiaries after the account owner's death.

4. CAN YOU GIVE US AN EXAMPLE?

A. Let's say Joe has an IRA that has a value of $100,000. Joe passes away and the entire amount of money in his IRA, because of the lack of prior planning, goes into his estate, and is distributed to his heirs immediately or within a few years. Those dollars are all considered new income, so $100,000 income is added to the estate and it is all taxable as ordinary income, so easily 25% of it could go to taxes.

IRA Account Value

$100,000

Taxes Due Upon Full Distribution

$25,000

 

After Tax Distribution

$75,000

B. Joe could have set the account up with his 23-year-old granddaughter as the beneficiary. At Joe's death, the distribution in the IRA could be spread out over his granddaughter's lifetime, and the results are significant.

C. Let assume that after Joe's death, the IRA grew at an annual rate of 6%. By taking just the required minimum distributions over the granddaughter's lifetime the projected distributions would be $969,000. These are gross distributions, and there would be income taxes to be paid based on granddaughter's marginal tax bracket. But it is easy to see, the distributions available to the family are much greater after having made the steps available through proper planning.

Distributions Over Granddaughter's Life Expectancy $969,000

CLOSE: Wow. Proper planning with your IRAs and 401(k)s can create huge benefits for your family.