According to the Federal Reserve, it is estimated that there are now over $13 trillion in retirement accounts. Retirement accounts make up the majority of many people’s estates and, unfortunately, many owners of IRAs and their financial advisors are not aware of all of the complicated tax laws regarding distributions from these retirement accounts.
Why is this? Because retirement accounts are different! People often forget that retirement accounts have to be in the name of an individual and the beneficiary designations of retirement accounts will override the beneficiaries of any of the other estate planning documents, such as your trust, will, etc. Therefore, you must separate the retirement accounts from the rest of your estate and establish a proper plan for distribution of these assets.
Although many individuals have established complex estate planning strategies, such as revocable living trusts, irrevocable life insurance trusts, etc., many individuals have not addressed the complex estate planning issues of inheriting an IRA.
I have often heard IRAs referred to as “Individual Riddle Accounts” because the rules can be very complex and cause many mistakes. IRA accounts are significantly different from most of the other assets in your estate because they:
vÂ Â Â Â Â Do not pass through the will (unless payable to an estate)
vÂ Â Â Â Â Are not subject to probate (unless payable to an estate)
vÂ Â Â Â Â Receive no capital gains treatment
vÂ Â Â Â Â Receive no step-up in cost basis upon death
vÂ Â Â Â Â Cannot be gifted (in most cases)
vÂ Â Â Â Â Title cannot be transferred to a trust
vÂ Â Â Â Â Are subject to Required Minimum Distributions
Let us review these issues in detail:
First of all, your IRA account has a beneficiary, which will override everything that you have in your will or living trust. For example, you might have changed your will or trust to reflect new beneficiaries of your estate. However, if you do not change the actual beneficiaries on your IRA account, then that won’t make any difference! Your IRA accounts do not pass through your will or your living trust in most cases, and therefore this must also be taken into consideration when revising any estate plan.
IRA accounts also are not usually subject to probate. For example, if you have an ordinary will, most of the assets inside your estate will pass through probate, unless you have a living trust or your accounts are held as joint tenants with someone else.
Most of your other assets are subject to reduced capital gains tax rates if you sell them after one year. However, any distributions from an IRA are taxed as ordinary income and not at lower capital gains tax rates.
In addition to this, there is no step-up in cost basis upon the death of the IRA owner. Most other assets owned by an individual receive a step-up in cost basis upon the death of the person, eliminating all capital gains on those assets up to that point in time.
Another major issue is that IRA accounts cannot be gifted in their current form. For example, if you want to give an appreciated stock that is held outside of an IRA directly to another individual, you can do that at any time. However, if you want to give some of your IRA to someone else, you must first take a distribution, pay the income tax on this, and applicable penalties, if any, and then make the gift.
Please remember that you should not place the title of an IRA into a trust! If you do so, this may cause immediate taxation!
The beneficiary can be in the name of a trust, but the title of any IRA accounts must be in the name of an individual. It is extremely important to review your IRA accounts to make sure that the titles and beneficiaries are held properly.
While there has been some recent talk that an individual can transfer title of their IRA to a trust, this area is currently uncertain and we do not recommend doing so without first obtaining the approval of the IRS through a private letter ruling.
And, last but not least, IRA accounts are the only assets in your estate that require you to take out a minimum distribution.
Many people are faced with very important decisions when they inherit an IRA. To top it all off, if their decision is not the best choice, it is usually irrevocable!
Unfortunately, IRA accounts are subject to many different types of taxes and penalties upon death, which is often referred to as the “triple tax syndrome.” This is comprised of estate and inheritance taxes, federal and state income taxes and possibly even additional penalties, which can lead to tax erosion of 65% or more!
There are many taxes that can apply to retirement accounts:
|vÂ Â Â Â Â Estate Taxes (up to 45%)vÂ Â Â Â Â State Inheritance Taxes (up to 13%)vÂ Â Â Â Â Federal Income Taxes (up to 35%)
vÂ Â Â Â Â State Income Taxes (up to 9.3%)
vÂ Â Â Â Â Generation Skipping Tax (45%)
vÂ Â Â Â Â 59 Â½ Penalty Tax (10%)
vÂ Â Â Â Â Minimum Distribution Tax (50% post age 70 Â½)
Since the individual who accumulated them owns these retirement accounts, they are included in that person’s taxable estate and therefore are subject to federal estate and state inheritance taxes. Additionally, you must remember that retirement accounts accumulate on a tax-deferred basis, which means you have not paid income taxes on these assets. Thus, upon death, these assets are subject to federal and state income taxes. In addition to this, there may also be penalties, as we will soon see, that are often referred to as excise taxes by the government.
People often like to leave assets to their grandchildren upon their death. The first $2,000,000 transferred (this amount increases in future years) is considered the Generation Skipping Tax (GST) exemption. Anything beyond that is subject to the 45% GST.
Additionally, there is a 10% penalty for premature distributions from most IRAs prior to age 59 Â½.
Finally, we have the minimum distribution penalty tax that is equal to 50% of the required minimum distribution that should have been taken from the retirement account, but was not, in a given year.
The information herein takes into consideration the numerous tax law changes in the “Final Regulations” issued by the IRS on April 16, 2002, and in the Pension and Protection Act of 2006 (PPA). However, these rules and laws may be subject to significant changes in the event of any amendment, correction, or interpretation of the current tax law. Please make sure that any advice you receive is current with respect to existing tax laws.
Improper decisions can be financially devastating. Therefore, it is extremely important that you seek qualified, competent financial counseling before you make your final decision with regard to what action you will take.
These tax laws pertain to most retirement accounts, including, but not limited to, Individual Retirement Accounts (IRAs), Profit Sharing Plans, 401(k) Plans, Employee Stock Ownership Plans (ESOPs), and most other defined contribution plans. However, many of these rules do not apply to non-qualified plans, such as Section 457 Plans, non-qualified deferred compensation plans, Roth IRAs, and many other plans. In addition to this, some of these rules do not apply to 403(b) Plans, also known as Tax Sheltered Annuities (TSAs). These types of plans have additional specific rules with respect to their minimum distributions.
Sometimes advisors, banks and brokerage firms are not familiar with these complicated tax laws. One of the most important concerns of these distribution rules is, of course, the tax law. Whatever you do, make sure you deal with someone who is very familiar with the tax laws governing these retirement distribution rules.
NOTE: It is extremely important to remember that there are usually two sets of rules:
- The IRS rules
- The IRA Custodian or Retirement Plan Administrator Rules
You must use the stricter of these two sets of rules! Many people are not aware that the custodian is not always current with respect to new tax laws. In fact, the IRS, on many occasions, states that although their particular rules are allowed, the specific contract of the IRA custodian or retirement plan must also reflect these rules in order for the IRS tax laws to be used. If the current retirement plans are not amended to reflect new IRS law changes, the existing retirement plan rules take precedent! Therefore, it is extremely important not only to know what the IRS allows, but what your custodian allows! Please make sure that you review your agreement carefully.
The purpose of this book is to review not just what to do, but what not to do. You have heard of the expression, “Learn by your mistakes.” Well, I am a big believer that it is cheaper to learn by other people’s mistakes!
I’ve assisted hundreds of people with their IRA rollovers and inheritances and I have personally seen over millions of dollars worth of mistakes in retirement distributions. My goal in writing this, is to explain some of the most common mistakes so that hopefully you can avoid them in your own situation! Â Â These areas include
vÂ Â Â Â The information necessary to identify potential problem areas when dealing with an “Inherited IRA”;
vÂ Â Â Â A summary of the various tax laws, regulations, rules and private letter rulings that may affect your inherited IRA decisions;
vÂ Â Â Â A discussion of the importance of choosing the right beneficiary or beneficiaries for your retirement accounts;
vÂ Â Â Â Information and guidance that will help you have an informed discussion with your financial advisor about the topics raised in this booklet, taking into account your own specific situation.
We highly encourage you to make an appointment if you are:
- Concerned about choosing the right beneficiary for your existing IRA;
- Ready to retire soon and concerned about understanding your options;
- Interested in obtaining more information about Roth IRAs. Required minimum distributions from Roth IRAs are significantly different than traditional IRAs, and with the proper planning you can use them to avoid many of the minimum distribution rules applicable to traditional IRAs.
In order to help avoid some of the common mistakes that people make, it is important for you to understand some of the basics of the tax laws. We would be happy to assist you in that area as well.
About Jerry Lynch:
Jerry Lynch is President of JFL Consulting and has over 23 years in insurance and financial planning, working with individuals in a variety of different planning areas.Â He is one of the few advisors to be listed in the 2004-2009, â€œAmericaâ€™s Top Financial Plannersâ€ by Consumer Research Council of America and listed as a 5 Star Advisor in the Paladin Registry.Â In addition, Jerry is a regular contributor to the Star Ledger, WABCâ€™s Talk Radio, and CNBC.Â He can be seen regularly on CNBCâ€™s, â€œOn the Moneyâ€ as well as â€œThe Big Idea with Donny Deutschâ€.
If youâ€™d like a copy of this article sent to someone else who would benefit from this information, please contact Pam Karkenny at JFL Consulting, Inc.Â (973) 439-1190.