Category: Qualified Plans
Tags: Estate Planning, Income Tax, Estate Tax, Retirement, IRAs


The IRS Loves Retirement Accounts

Posted on: November 19th, 2009
Planning for tax-qualified plans, which includes IRAs, 401(k)s and qualified retirement plans, requires a careful examination of the potential taxes that impact these assets. Unlike most other assets that receive a “basis step up” to current fair market value upon the owner’s death, IRAs, 401(k)s and other qualified retirement plans do not step-up to the date-of-death value. Therefore, beneficiaries who receive these assets do so subject to income tax. If your estate is subject to estate tax, the value of these assets may be further reduced by the estate tax. And if you name grandchildren or younger generations as beneficiaries, these assets may additionally be reduced by the generation-skipping transfer tax. All tolled, these assets may be reduced by 70% or more.
 
There are several strategies available to help reduce the impact of these taxes:
 
  • Structure accounts to provide the longest term payout possible (stretch).
  • Name a Retirement Trust as Beneficiary
  • Take the money out during lifetime and pay the income tax, then gift the remaining cash either outright or through an irrevocable life insurance trust.  Or consider a Roth conversion.
  • Take the money out during lifetime and buy an immediate annuity to provide a guaranteed annual income, to pay the income tax, and to pay for insurance owned by a wealth replacement trust.
  • Name a Charitable Remainder Trust as beneficiary with a lifetime payout to your surviving spouse. The remaining assets would pass to charity at the death of your spouse.
  • Give the accounts to charity at death.
 
Structure Accounts to Provide the Longest Term Payout Possible.
 
Structuring the accounts to provide the longest term payout possible is the most simple and therefore the most common option. With this strategy you name beneficiaries in such a way that requires them to withdraw the least amount possible as required minimum distributions, or those distributions that must be made in order to avoid significant penalties. To achieve this maximum “stretch-out,” you should name individuals who are young (e.g., children or grandchildren, although there are special considerations when naming grandchildren or younger generations) as the designated beneficiary of your tax-qualified plans. Significantly, the beneficiary should take only those minimum distributions that are required by law. The younger the beneficiary, the smaller these required minimum distributions.
 
This can be accomplished by naming the beneficiaries individually or by directly naming their shares of a trust. Frequently, the surviving spouse is named as the primary beneficiary so that he or she may roll over the account into the surviving spouse’s name and treat it as his or her own account. Alternatively, if you are concerned the loss of creditor or divorce protection by naming the surviving spouse individually, you can name a trust for the survivor’s benefit.
 
 
Name a Retirement Trust as Beneficiary to Ensure the Longest Term Payout Possible.
 
Naming a beneficiary outright to accomplish tax deferral with a tax-qualified plan has several disadvantages. First, if the beneficiary is very young, the distributions must be paid to a guardian; if the beneficiary has no guardian, a court must appoint one. Another disadvantage is the potential loss of creditor protection or bloodline protection, particularly where the named beneficiary is the surviving spouse. A third, practical disadvantage is that many beneficiaries take distributions much larger than the required minimum distributions, often consuming this “found money” in only a couple of years.
 
However, by naming a trust as the beneficiary of your tax-qualified plans, you can ensure that the beneficiary defers the income and that these assets remain protected from creditors or a former son or daughter-in-law. A stand-alone Retirement Trust (separate from your revocable living trust and other trusts) can help ensure that it accomplishes your objectives while also ensuring the maximum tax deferral permitted under the law. This trust can either pay out the required minimum distribution to the beneficiary or it can accumulate these distributions and pay out trust assets pursuant to the standard you set in advance (e.g., for higher education, etc.)
 
 
Take the Money Out During Lifetime and Pay the Income Tax, Then Gift The Remaining Cash Either Outright or Through an Irrevocable Life Insurance Trust.
 
Another option is to take the money out during lifetime and pay the income tax, then gift the remaining cash either outright via lifetime giving or through an irrevocable life insurance trust. If you desire to make the gifts through an irrevocable life insurance trust, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds free of income and estate tax and, under certain circumstances, free of generation-skipping transfer tax.   
 
A conversion to a Roth IRA during 2010 when the $100,000 income limitation is removed and taxes can be split between 2011 and 2012 is a variation on this option.
 
Take the Money Out During Lifetime and Buy an Immediate Annuity to Provide a Guaranteed Annual Income, to Pay the Income Tax, and to Pay For Insurance Owned by a Wealth Replacement Trust.
 
Another option is to withdraw your IRA or qualified plan and purchase an immediate annuity, which will generate a guaranteed income stream during your life (or during the lives of you and your spouse). You can use this income stream to pay the income tax caused by the withdrawal, and also pay the premiums on life insurance owned by a Wealth Replacement Trust. Again, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds from the Wealth Replacement Trust free of income and estate tax and, under certain circumstances, free of generation-skipping transfer tax.
 
Alternatively, it may make sense to use other assets to purchase the immediate annuity, saving the IRA for family members. This strategy makes the most sense when you can defer the income tax on the IRA or qualified plan for many years by naming a very young beneficiary.     
 
Name a Charitable Remainder Trust as Beneficiary With a Lifetime Payout to Your Surviving Spouse; the Remaining Assets Pass to Charity at the Death of the Your Spouse.
 
Yet another option is for you to leave the accounts to a Charitable Remainder Trust (“CRT”), a type of trust specifically authorized by the IRS. These irrevocable trusts permit you to transfer ownership of assets to the trust in exchange for an income stream to the person or persons of your choice (typically you or, if you are married, your spouse or you and your spouse) for life or for a specified term of up to 20 years. With the most common type of Charitable Remainder Trust, at the end of the term, the balance of the trust property (the “remainder interest”) is transferred to a specified charity or charities. Charitable Remainder Trusts reduce estate taxes because you are transferring ownership to the trust of assets that otherwise would be counted for estate tax purposes.
 
Naming a Charitable Remainder Trust will allow the accounts to pass free of any estate taxes and will pay to the surviving spouse an annual income stream, either in a specified dollar amount or the lesser of the trust income or a percentage of the net fair market value of the assets.
 
With this option, a testamentary CRT may be established upon the death of the first of you to die. The survivor is guaranteed an annuity for his or her lifetime that will help maintain his or her lifestyle should the family’s income stream be insufficient. The property will only go to the CRT at death. It is only at death or incompetency that this aspect of your estate plan becomes irrevocable. However, even after the first death occurs, the survivor still has the ability to change which charities are to receive the assets or to bypass the CRT entirely. At the second death, the property in the CRT will pass to charity.
 
Give the Accounts to Charity at Death
 
Another relatively simple option is for you to give the accounts to charity at your death or at the death of the survivor of you and your spouse if you are married. This strategy is particularly attractive if you intend to make gifts to charity at your death and the question is simply what assets should you select. As a tax exempt entity, a qualified charity does not pay income tax and therefore receives qualified retirement plans free of income tax.
 
In other words, if your beneficiary is in a 35% tax bracket, a $100,000 IRA is worth only $65,000 in his or her hands, but worth the full $100,000 if given to charity. Therefore, it makes economic sense to give these assets to charity and give to your children or other beneficiaries’ assets that are not subject to income tax and which receive a step-up in basis to their date-of-death value at your death.
 
These are only a few of the more common planning solutions for tax-qualified plans. The right solution for you will depend upon your particular goals and objectives as well as your particular circumsta
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