Introduction
All that glitters is not gold. Very little is written about the downside of tax-deferred investing or its side effects. It is possible that IRAs can cause more harm than good — as we will explore in a moment. But first, let's review basic income taxes.
The Two Federal Tax Systems
Did you know there are actually two tax systems in our country — one you must participate in and one that is optional? The two systems are the Voluntary Tax System and the Involuntary Tax System.
The involuntary system represents taxes you simply must pay, like income taxes and capital gains taxes. Voluntary taxes are just that — voluntary. These are taxes you voluntarily pay that you don't have to. Someone needs to pay them, but it doesn't have to be you.
Your IRA Is Not All Yours
Suppose you're filling out a financial statement for a bank and are asked to list your IRA and 401(k) balances. Suppose your balances total $100,000. What would you put down?
If you wrote $100,000, the bank wouldn't argue — but that number is not your actual net worth in those accounts. Your true net worth is only $70,000, because at least $30,000 belongs to Uncle Sam. At least 30% of all your retirement accounts are not yours. Your name may be on the statement, but you'll never spend that portion, and neither will anyone else. You can invest it, move it, watch it, and play with it — but you can't spend it. The government is simply allowing you to manage its money for a time.
The principal driver behind all tax-deferred investing is a single theory: that you will be in a lower tax bracket when you withdraw the money than when you made contributions. As we will see, this is a fallacy for many people.
IRA withdrawals are taxed at your or your beneficiary's highest marginal bracket. This means if you have any pensions, dividends, interest, or other income, the IRA withdrawal is added on top. One clear example: your IRA withdrawal could cause you to pay taxes on your Social Security benefits when you otherwise wouldn't.
With an estimated 70 million people expected to be drawing Social Security and Medicare, where is the money going to come from? Most analysts expect income taxes to rise in the future. Someone has to pay for the aging population. The fact is you don't control tax rates — but you do control the financial decisions you make today.
What about your beneficiaries? Other than a spouse, the beneficiary must either pay all taxes due when they receive the IRA proceeds, or "stretch" it over their lifetime. Both options come with significant pitfalls. If your son or daughter pays the taxes, at least 30% goes to income taxes immediately. If your estate is taxable, the combined rate of income and estate taxes can exceed 70%. If they choose to stretch the IRA, they must take equal installments over their life expectancy.
What you may not be aware of is that there is a whole host of unpleasant consequences for your heirs. Since IRA distributions are added to adjusted gross income, the beneficiary may face:
- Loss of itemized deductions that are phased out at higher income levels
- Loss of personal exemptions
- Disqualification from certain student loans and grants
- Inability to deduct higher education expenses
- Inability to deduct student loan interest
- Inability to make a tax-deductible IRA contribution
- Ineligibility for a Roth IRA
Medical expenses and miscellaneous itemized deductions are all subject to limits based on a percentage of adjusted gross income. The higher the income, the fewer deductions are available. So the idea that your heirs will only pay taxes at their highest marginal rate understates the true cost — when you factor in the loss of other benefits and deductions.
IRAs and Estate Planning
One of the most overlooked problem areas is the conflict between IRAs and estate plans. Many people have carefully drafted wills, living trusts, and trusts designed to protect their heirs. But what about your IRA?
IRAs pass directly to the named beneficiary in your custodial agreement — regardless of what your will says. IRAs are not probate assets. This means you lose all estate planning benefits of trusts when assets pass directly to an heir.
If you transfer the title of an IRA to a living trust, the entire amount becomes taxable in that year. If you name a trust as beneficiary, chances are the entire amount will be taxed in the year of your death. Proper estate planning can place assets beyond the reach of creditors and offer real benefits to heirs — protecting them from lawsuits, poor management, future ex-spouses, and IRS levies. But only if it's structured correctly.
Fortunately, there are sophisticated tools that can allow you to leave IRA assets in trust without an immediate tax — and other tools that convert a taxable asset into a tax-free inheritance. Here are three ideas worth considering:
1. Do a Quick Beneficiary Check
Are all beneficiary designations on your retirement plans and insurance policies consistent with your estate plan? Can your beneficiaries handle large lump sums? Have you accidentally named a trust as the beneficiary of a tax-deferred asset?
2. Consider an IRA Trust
There is no legal instrument specifically named an "IRA trust," but a trust may be drafted so that IRA assets fund the trust without triggering an immediate tax. This allows you more control over the management of a large asset. The IRS will still require beneficiaries to take minimum distributions, but you can have assets professionally managed and control who the final beneficiaries are.
3. Convert a Taxable IRA into a Tax-Free Death Benefit
Due to the favorable tax treatment of certain insurance products, it is possible to re-route IRA assets through an insurance vehicle so that your heirs pay no taxes on the same assets. This technique won't work for everyone, but consider:
A couple in their late 60s determines they probably will not spend their entire IRA. Depending on their health, they may be able to fund a life insurance policy that equals the IRA balance — but passes to heirs completely tax-free and potentially outside their taxable estate.
A Final Word
IRAs, income taxes, and estate taxes are complex subjects. Careful consideration should be given to any planning technique under the guidance of a qualified professional. Tax and estate planning is an ongoing effort. Since tax laws and family dynamics are always changing, plan on revisiting these issues regularly.
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