What You Don’t Know About Your IRA Can Hurt You
by David Disraeli
All that glitters is not gold. Very little is written about the downside of tax-deferred investing or the 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 that 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 tax system represents taxes you simply must pay, like income taxes and capital gains taxes. In other words, taxes are almost impossible to avoid. Voluntary taxes are just that – voluntary. These taxes are taxes that you voluntarily pay the government that you don’t have to. Frankly, we need people to voluntarily pay more taxes, but it doesn’t have to be you!
YOUR IRA IS NOT ALL YOURS
Suppose you are filling out a financial statement for a bank and are asked to put down your IRA and 401k balances. Suppose further that your balances are $100,000. What would you put down, $100,000? If you did, the bank wouldn’t argue with you, but $100,000 is NOT actually your net worth in those accounts. Your net worth is only $70,000 because at least $30,000 belongs to Uncle Sam. That’s right, at least 30% of all your retirement accounts are NOT yours. Your name may be on the statement but you’ll never spend it 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 allowing you to manage its money for some time,
The principal driver behind all tax-deferred investing is the same. The theory is that you will be in a lower tax bracket when you draw out the money than you were when you made the 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 that if you have any pensions, dividends, interest, or other income, the IRA withdrawal is added to the top. One clear example is that your IRA withdrawal could cause you to pay taxes on your social security benefits when you otherwise wouldn’t. But wait, the picture gets bleaker. With an estimated 70,000,000 people expected to be drawing social security and Medicare, where is the money going to come from? Most people expect income taxes to go up in the future. Someone has to pay for the aging population and the war. The fact is you don’t have control over the tax rates, but you do have control over the financial decisions you make.
Suppose you can live on other assets and have the luxury of making the minimum withdrawals from your IRA. Suppose further that you do wind up paying taxes at a lower rate than when you funded the IRA. What about your beneficiaries? Other than a spouse, the beneficiary must either pay all the taxes due when they receive the IRA proceeds, or they can “stretch” it out over their lifetime. Both options come with all sorts of pitfalls. If your son or daughter chooses to pay the taxes, at least 30% or more will go to income taxes right away. If your estate is taxable, the rate can climb over 70% due to the combination of income and estate taxes. If they choose to stretch the IRA, they must take equal installments over their life expectancy.
It is true, however, that an IRA left to someone is money they didn’t have even if some of it gets eaten up with taxes. What you may not be aware of is that there is a whole host of consequences to your heirs which can be very unpleasant. Since IRA distributions are added to adjustable gross income, here is a short list of unpleasant consequences facing the beneficiary:
1. They may lose the benefit of itemized deductions that are phased out a higher income levels
2. They may lose the benefit of their personal exemptions
3. They may not qualify for certain student loans and grants for their children
4. They may not be able to deduct higher education expenses
5. They may not be able to deduct interest on student loans
6. They may not be able to make a tax-deductible IRA contribution
7. They may be ineligible for a Roth IRA
Things like medical expenses and miscellaneous itemized deductions are all subject to a limit based on a percentage of adjusted gross income. The higher the income, the fewer deductions are available. So the thought that your heirs will only have to pay taxes at their highest marginal rate is not true when you add the loss of other benefits and deductions.
IRAS AND ESTATE PLANNING
One of the most overlooked problem areas I’ve seen is the problems associated with IRAs and estate plans. Many people have carefully drawn wills, living trusts, and trusts designed to protect their heirs. But what about your IRA? IRAs pass directly to the beneficiary(ies) named in your custodial agreement, no matter what your will says. This is because IRAs, among other assets, are generally not probate assets. You lose any estate planning benefits of trusts when you pass assets directly to an heir. What do you think happens when you put an IRA in a living trust or name a trust as a beneficiary? Taxes happen. An IRA must maintain its identity as an IRA to maintain its tax-deferred status. If you transfer the title of an IRA to a living trust, the entire amount is taxable in that year. If you name a trust beneficiary, chances are the entire amount will be taxed in the year of your death.
Proper estate planning can allow you to place assets beyond the reach of creditors and offer many benefits to your heirs like protecting them from lawsuits, poor management, future ex-spouses, and even IRS levies. Fortunately, there are sophisticated tools that CAN allow you to leave IRA assets in the trust without an immediate tax and other tools that allow you to convert a taxable asset into a tax-free estate for your heirs. The scope of this article won’t permit an in-depth discussion of each of these techniques, but here are a few ideas worth considering:
1. Do a quick beneficiary check
Are all the beneficiary designations of your retirement plans and insurance policies consistent with the goals of your estate plan? Can your beneficiaries handle large, lump sums of money? Have you left 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”. However, a trust may be drafted in such a way that the IRA assets can fund the trust without an immediate tax. The advantage of this type of document is that it allows you more control over the management of a large asset. The IRS will still require the beneficiaries to take the minimum distributions, but you can have the assets professionally managed and control who the final beneficiaries are instead of risking the money going to the wrong people.
3. Consider Converting a Taxable IRA into a Tax-Free Death Benefit
Due to the favorable tax treatment of certain insurance products, you can re-route IRA assets through an insurance vehicle so that your heirs will have NO taxes to pay on the same assets. This technique won’t work for everyone, but consider the following example:
A couple in their late 60s determines that they probably will not spend their entire IRA. Depending on their health, they may be able to fund a life insurance policy that will equal the IRA but will NOT be taxed to anyone and can be moved outside their taxable estate for estate tax purposes.
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 tax professional. Tax and estate planning is an ongoing effort. Since tax laws and family dynamics are always in flux you should plan on revisiting these issues regularly. For more information on passing IRAs “intact” see below:
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