Death & Taxes:

Death and IRAs

Everyone must die someday. We as humans like to live as well as we can towards the end of our lives, yet we want to be able to leave our children as well off as possible too. People with individual retirement accounts have this in mind when they set them up. However the IRS is thinking something all together different.

The IRS wants your client's money and they don't try to hide the fact. Anyone with an IRA who reaches the age of 70 years must start making annual withdrawals from their accounts. Anyone who makes withdrawals before the age of 59 ½ years is hit with a 10% penalty on top of regular income taxes. Between the age of 59 ½ years and 70 ½ years, there is not the 10% penalty on the money but there is a 15% penalty on the money if your client withdraws more than $155,000 a year.

Once your client reaches the age of 70 years in a tax year, your client have until April 1st the next year to start making their annual withdrawals from the IRA. The wise thing to do is to wait until this age because this way the money will keep growing tax deferred in the account over the years. Once your client reaches this age, try to make the lowest withdrawals possible on the account. The important thing is to make that withdrawal by April 1st. If they do not, their IRA is liquidated and taxed close to the 56% rate.

Who is your client going to leave this IRA to? Most people leave it to their spouses. It usually makes for a wise decision because after the owner passes away, the spouse has something to live on. Your client may also choose to mix the two and leave it to both their children and their spouse.

Let's look at the first scenario. When your client leaves the IRA to his or her spouse, the spouse can restart the IRA in a way. The spouse can name heirs to the IRA, this way the account keeps going for another few decades, appreciating in value over the years tax deferred. This can be used in combination of fixed life expectancy, under which your client can set certain years for the distribution of the payout or they can pick the recalculated method, under which every year the life of the owner is recalculated, meaning they could never outlive their IRA. In addition, they could pick the joint payout method, meaning they would lower the minimum IRA distribution each year and would let their IRA appreciate tax deferred.

The advantage of using the combination of the fixed life and the recalculated method instead of using just the fixed life is as follows:

  • The owner of the IRA should have a recalculated method and the spouse should have a fixed life term. For example - say the owner has a life expectancy of 12 years using the recalculated method and the spouse has a 20-year fixed life term (this means that after 20 years, the account will be liquidated.)
  • If the owner dies, regardless of the term, the spouse can restart the IRA under her name and name beneficiaries, extending the life of the IRA.
  • If the spouse dies before her term is up, she can still stay within the IRA as a ghost beneficiary, and for the remaining years of her term, the IRA keeps appreciating tax deferred.

Second scenario. Your client wants to leave the IRA to their children. They can choose a payout jointly with one of their sons or daughters who is, for example, 25 years their junior. When your client dies, the child gets the IRA and for the next couple of decades the account keeps going, appreciating in value tax deferred. They can then choose to leave the IRA to their heirs.

An even better method is building a charitable remainder trust. Under this trust, the heirs will get the payout each year off the interest, leaving the principal untouched. This is usually recommended for an IRA that is over one million dollars. When the heirs pass away, the trust goes to whichever charity the IRA owner named for the trust when he or she set it up. One advantage of this trust is that the principal in the IRA is never touched by taxes. The heirs have to pay taxes on the payout, but even that is estate tax deductible. The aim of the game is to save money on the tax bill that will result from the payout of the entire IRA. This way your client can do a good deed by leaving the money to a charity and also saving their heirs some taxes.

The lesson to be learned here is that it is most likely in your client's best interest to use a combination of the recalculated method and the fixed life term payout for themselves and their spouse, choosing joint payout. However, use the charitable remainder trust when they name their children as their heirs. Reminder: advise your client to do this before April 1st of the year that they turn 70 years old.