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