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IRAs Create Special Estate Planning Concerns

Eighteen-year-old Sarah tried to calm her excitement. She had been named the beneficiary of her Grandpa Jack’s IRA (Individual Retirement Account). While all of the grandchildren had been named in Grandpa Jack’s will, she was the only one to get a separate gift. Visions of a new car and new clothes began to dance through her head.

“Your grandfather named you as the beneficiary of his $1 million IRA, along with his wife, Eileen, who is, I believe, deceased?” The financial planner peered over his glasses at Sarah. “Correct?”

Sarah nodded. “Yes, she died last year.” She gazed politely at the planner. “So, do I get a check for the million dollars now or do I have to wait for a while?”

“Actually, you will never get a check for the full amount. You have to pay tax on any distributions and any outright withdrawals involve a significant penalty. Since the IRA must be included in your grandpa’s estate, you may have to pay estate taxes as well.”

“Are you kidding me?” Sarah glared at the man. “I just graduated from high school. How am I supposed to afford that?”

“Well, the best approach may be to take the monthly distributions permitted by the IRA contract. That way you will pay much less in taxes and the IRA will continue to make money.” He tapped his pen on some paperwork. “You can do that for up to five years and then you have to cash out the IRA. The taxes will be deducted from the final payoff.”

“What about the estate taxes. Will they go away, too?”

The planner sighed. “No, I am afraid not. The IRA will still be taxed at its current value. You may be forced to pay those taxes out of the IRA proceeds. However, you will need to check with your grandfather’s attorney. Perhaps he made provision for paying the taxes out of his estate. Then you wouldn’t have to pay anything.”

Sarah brightened. “Well, I’m sure Grandpa Jack took care of it. No way he would have tried to stick me with those taxes twice.”

Retirement asset planning is considered a deferred tax investment. Generally, money deposited into an IRA can be deducted from taxable income, which results in lower income taxes. However, there are limits on the size of the investment qualifying for a deduction.

The monies invested in an IRA grow tax-free. The investor isn’t taxed until distributions are made and then the distributions are taxed as ordinary income tax rates. There are two benefits from a tax perspective. First, since IRA distribution usually takes place during retirement, when income is lower, the distributions are taxed at a lower rate. Second, there is no tax penalty for any capital gains earned on the investment.

In estate planning, IRA’s require special consideration. For example, it might be smart to cash out IRA funds early, pay the taxes owed and invest the monies in other after-tax assets, ones that impose no income tax burden on the beneficiaries and are removed from the estate, resulting in no additional taxation.

Prior to taking those steps, however, it is important to consider these questions:

  • Upon death, what taxes will be due? Not only are federal income and estate taxes a consideration, but local and state estate, inheritance, and income taxes as well.
  • Who will be required to pay estate taxes? When a surviving spouse is the sole beneficiary, the value of an IRA is often offset by the federal marital estate tax deduction. If the beneficiaries do not include a spouse, life insurance policies can be purchased to cover any resulting liabilities. Sometimes, a will provides that the taxes be paid out of the estate. When no provision is made to pay taxes, all heirs may face a significant reduction in their inherited share or—worst case scenario—the IRA will have to be cashed out to pay the estate tax penalty.
  • What is the best post-death use of the IRA? Post-death IRA proceeds can serve any number of purposes, such as funding education, special health needs, or to supplement income. It is important to determine whether the post-death use of an IRA is the best way to accomplish that. Often, post-death IRA proceeds are used to make a charitable gift. The IRA will be included in the owner’s estate, but receive a corresponding deduction for a charitable contribution, resulting in no tax penalty. In addition, the recipient charity is not required to pay income tax on the distribution.
  • Should the IRA be cashed out prior to death? Since the value of the IRA will be included in the owner’s estate, it might be wise for those with high-value estates or estate tax concerns to cash out the IRA prior to death and invest the proceeds in more tax-advantageous instruments or use the monies to fund a trust. In addition, not all IRA contracts are alike. Each has specific requirements and procedures for cashing out an IRA, as well as paying-out proceeds to beneficiaries. It is important to review those requirements to determine the impact on potential heirs.

While IRAs provide many tax advantages, they are a complicated estate planning tool. It is important to consult with an estate planning attorney to determine whether, after your death, your IRA will truly benefit your beneficiaries.

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