Estate Planning – Proper Treatment of IRA accounts

Someone recently asked me what happened to their IRA after he died. He was under the impression that since the total value of his estate was under $1 million, no one would have to pay taxes on his IRA after he died. (Note the $5.12 million estate tax exclusion for 2012 is scheduled to decline to $1 million in 2013 unless Congress changes the law, which is why the million dollar threshold is important.)

Was it a Roth IRA? I asked. Nope. It was a regular IRA. I next asked who he had named as the beneficiary. Beneficiary? He said.

I figured he was not alone, hence the post.

If you own an IRA and have not found the elixir of immortality (and the tax laws don’t change) regardless of the total size of your estate, unless you give it away to charity, someone is going to have to pay income taxes on the distributions from your IRA.

If you already know everything in your estate planning around your IRA is splendid, congratulations. If not, here’s a three-step approach you should consider. Depending on your knowledge and patience, you might be well advised to seek professional estate tax guidance while you implement this suggestion.

Step 1: Determine what beneficiary designation you have in effect.

Step 2: Determine the required distributions and tax effects of your current designation.

Step 2: Modify your designation if appropriate.

Step 1:

The recordkeeper for your IRA should have your beneficiary designations on file. If you are not completely sure of your current beneficiary designations, ask the recordkeeper. (If that is a mutual fund, brokerage firm or the like, you can probably find the information through your online account. That’s how I review and change mine at Vanguard.)

Step 2:

The rules around the timing and amount of distributions from an inherited IRA are very complex, and I won’t deal with them here. You’ll need a good tax advisor or plenty of patience to sort them out. This much is always the case: whenever a regular IRA makes a distribution, it triggers a taxable event. It doesn’t matter if you took the distribution, the estate takes the distribution or the IRA passes to a specific beneficiary and that person takes the distribution. Get a payment; owe income tax.

That means:

If you are giving part of your estate to a charity, gifting IRA monies makes a lot of sense because the money passes tax-free. (And if you are subject to the estate tax, donations to charity are subtracted from your estate prior to determining the tax.)

If you are giving part of your estate to someone with a much lower marginal tax rate, gifting IRA monies also makes sense since the beneficiary will net more that way than if your estate pays the income tax and then gives the remainder to your beneficiary.

If you are giving part of our estate to someone with a higher marginal tax rate, gifting an IRA benefits government not that beneficiary because your beneficiary will pay more taxes than your estate would have.

If the beneficiary has the same marginal tax rate as you, then the primary consideration becomes when the IRA can/must be paid out.

Step 3:

In January of each year I estimate the value of my estate upon my demise. When I do that, it’s important to apply realistic values of assets with no readily available market value (such as housing.) When in doubt, go for a slightly conservative value and then round down.

I then determine the amounts I expect to go to each charity I’ve named in my estate plan.

I then take those amounts, divide by the total value of my taxable IRA (not Roth IRA) and designate that percentage to go to each charity.

A simplified example may make it all clear:

Total conservative estimated estate value is say $1,000,000.

Amount going to The Nature Conservancy is 10% or $100,000.

Total value of taxable IRA is say $400,000.

Total value of other assets is $600,000, and we’ll assume they are not subject to income taxes.

Percentage of taxable IRA for The Nature Conservancy (TNC): $100,000/$400,000 = 25%

In addition to the analysis I do in January, I also review these calculations immediately after I take out my annual distribution. Depending on how the investments have done in the intervening period and the size of the distribution relative to the total value, I may need to readjust my percentage allocations.

That in a nutshell is the strategy. Why bother?

In the example above, beneficiaries would ultimately have to pay taxes on the remaining $300,000 of the taxable IRA ($400,000 total minus the $100,000 going to TNC). If I had not designated The Nature Conservancy as a specific beneficiary for the IRA, only $40,000 of the IRA would have “gone” to them, leaving $360,000 of the IRA eventually taxable. The remaining $60,000 of the donation to TNC comes from the “nontaxable assets.”

If you are like Mitt Romney and have an average Federal tax rate of 15% (I’m not as lucky as he; I have to pay over 18% for 2011), here’s the difference:

When you give TNC the $100,000 from the IRA, the taxable amount is the $300,000 remainder, which generates $45,000 in taxes.

If TNC gets 10% of everything, then the remaining taxable IRA is $360,000 and the tax is $54,000.

That’s $9,000 the government gets rather than your beneficiaries. While poor planning on the part of politicians has created the Federal Government’s budget woes, that’s no reason to give them extra funds because of poor planning on your part.

~ Jim

The Latest Republican Debates: Red Meat for Warmongers, Silence on Real Answers

I’ve found the Republican debates interesting on a number of fronts: the questions the reporters asked (or didn’t); the way the politicians answered (or didn’t) and the Mitt Romney challenger-of-the-week club that almost everyone other than Ron Paul and Jon Huntsman has joined. (Ron Paul is excluded because he is the perpetual thorn in the Republicans’ side and Jon Huntsman because he didn’t bother trying to win Iowa—and maybe because people who appear to talk straight have no chance of winning these days.)

What struck me as very worrisome at the Saturday night debate (1/7/2012) was the aggressively militaristic position taken by all candidates other than Ron Paul and Jon Huntsman. Paul’s reasoned points regarding the size, cost and performance of the last decade of Republican wars gets lost in the isolationism inherent in his extreme libertarian positions. That’s too bad.

Huntsman, however, is not an isolationist. He is an internationalist and one who has experiences none of the other candidates have had, including his years as ambassador to China. I find his position on Afghanistan interesting. He essentially says our work is done: declare victory and withdraw. The Taliban are not in control. Those who perpetrated the 9/11 attacks on the US are dead. Why are we still there?

When asked by a reporter if he isn’t afraid that by leaving Afghanistan a civil war will break out, he says he thinks one will break out regardless of when we leave. I can only wish President Obama would listen to Huntsman on this war.

Which now brings me to the rest of the republican contenders. They lambasted Obama for withdrawing troops from Iraq, for “allowing Iran to develop nuclear weapons,” and for proposing to reduce the nation’s defense budget. The question that was not asked of them, nor did they proffer their own solutions, was this: what would you do differently?

In one of the debates, one of the contenders (I don’t remember which debate nor which person, which is kind of lame, but there you have it) indicated that Obama should have negotiated harder to keep our troops in Iraq. I am sure we could have forced our preferences by tying it to our providing aid. That would certainly have pushed Iraq into our enemies’ arms, and gotten more of our troops killed. Obama insisted that U.S. personnel would be subject to the U.S. legal system; Iraq would not agree and Obama pulled out the remaining troops. I’m glad a war Bush and his warmongers should never have started is finally over for us. If Iraq regresses into civil war, so be it. If that is their path, they would eventually find it once we withdrew, whenever that time might be.

Iran is suffering mightily for its pursuit of nuclear weapons, which is why they are making a big show of testing missiles and threatening to cut access to the Straits of Hormuz. Should they actually cut access, I have no doubt the U.S., in concert with other nations, would interpret that action as an act of war and react militarily. For the U.S. to be the aggressor would not achieve any political, economic (other than to our defense industry) or moral objective. We would again become the bully Bush projected to the world.

Lastly, Saturday night all except Paul and Huntsman excoriated Obama for daring to cut defense spending even though, as Paul pointed out, our defense spending dwarfs any other nation (or four or ten nations combined—depending on whose statistics one chooses to believe.). Recognize that all the Republicans with the exception of Jon Huntsman have signed a pledge to “not raise taxes.” Most want to lower taxes, particularly for corporations and those individuals with assets (by way of eliminating the capital gains tax and/or estate taxes). All agree that our current budget deficit is unsustainable.

The three legs of the stool they are proposing are (1) we can’t cut defense spending, (2) we can’t raise taxes (in fact we should lower them) and (for many) (3) we must “balance the budget.” The only way to balance this stool is on the back of cuts in nondefense spending. The question we must ask and force these candidates to answer is this: how EXACTLY are you going to cut spending?

Now, they are going to say that by cutting taxes and decreasing regulations their policies will increase federal government revenue. Since we are still in the early stages of an economic recovery, pretty much whatever we do, government revenues will increase some. Cutting taxes is no guarantee—Bush’s tax cuts preceded a very deep recession and the largest budget deficits in history.

To cure the current budget deficit without increased taxes would require a roughly 40% reduction in expenses. I’ll cut the candidates a break and grant them some improved tax revenues and assume they only need to cut total spending by 30%! Now, tell us exactly whose ox you are going to gore.

A pivotal question this election should answer is how the American people choose to address the fiscal imbalances we currently have. Democrats under Obama have one idea (cuts in the budget, including entitlements, combined with increases in tax revenues). Ron Paul, whether you like his solutions or not, has been clear in his desire to eliminate large chunks of the current federal government, including much of the defense budget and most so-called entitlements. Jon Huntsman’s approach has so far been nuanced. He has refused to rely on throwing red meat to the Republican base. His complete solution relies on a combination of cuts and increased taxes. While he has provided some specificity, especially around his changes to the income tax, like Obama’s approach, his is not yet completely transparent.

The other Republicans are not serious about providing voters with a real understanding of their policies. They are spouting red meat untruths for their far-right bases in order win the nomination. They refuse to tell us what we individually and collectively will need to give up in order to maintain the current defense spending, decrease current taxes and balance the budget.

Here is my suggestion if you can vote in the Republican primaries: Until the other candidates provide enough information so you know what the economic effects of their policies will be, I recommend you vote for Ron Paul or Jon Huntsman as your preferences dictate.

~ Jim