Planning for tax-qualified plans, which includes IRAs, 401(k)s and qualified retirement plans, requires a careful examination of the potential taxes that impact these assets. Unlike most other assets that receive a “basis step up” to current fair market value upon the owner’s death, IRAs, 401(k)s and other qualified retirement plans do not step-up to the date-of-death value. Therefore, beneficiaries who receive these assets do so subject to income tax. If your estate is subject to estate tax, the value of these assets may be further reduced by the estate tax. And if you name grandchildren or younger generations as beneficiaries, these assets may additionally be reduced by the generationskipping transfer tax. All tolled, these assets may be reduced by 70% or more.
There are several strategies available to help reduce the impact of these taxes:
- Structure accounts to provide the longest-term payout possible.
- Take the money out during lifetime and pay the income tax, then gift the remaining cash either outright or through an irrevocable life insurance trust.
- Take the money out during lifetime and buy an immediate annuity to provide a guaranteed annual income, to pay the income tax, and to pay for insurance owned by a wealth replacement trust.
- Name a Charitable Remainder Trust as beneficiary with a lifetime payout to the surviving spouse. The remaining assets would pass to charity at the second death.
- Give the accounts to charity at death.
Structuring the accounts to provide the longest-term payout possible is the most simple and therefore the most common option. With this strategy you name beneficiaries in such a way that requires them to withdraw the least amount possible as required minimum distributions, or those distributions that must be made in order to avoid significant penalties. This can be accomplished by naming the beneficiaries individually or by directly naming their shares of a trust. Frequently, the surviving spouse is named as the primary beneficiary so that he or she may roll over the account into the surviving spouse’s name and treat it as his or her own account. Alternatively, if you are concerned the loss of creditor or divorce protection by naming the surviving spouse individually, you can name a trust for the survivor’s benefit.
Another option is to take the money out during lifetime and pay the income tax, then gift the remaining cash either outright via lifetime giving or through an irrevocable life insurance trust. If through an irrevocable life insurance trust, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds free of income and estate tax and, under certain circumstances, free of generation-skipping transfer tax.
Another option is to withdraw your IRA or qualified plan and purchase an immediate annuity, which will generate a guaranteed income stream during the lives of you and your spouse. You can use this income stream to pay the income tax caused by the withdrawal, and also pay the premiums on life insurance owned by a Wealth Replacement Trust. Again, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds from the Wealth Replacement Trust free of income and estate tax and, under certain circumstances, free of generationskipping transfer tax.
Alternatively, it may make sense to use other assets to purchase the immediate annuity, saving the IRA for family members. This strategy makes the most sense when you can defer the income tax on the IRA or qualified plan for many years by naming a very young beneficiary.
Yet another option is for you to leave the accounts to a Charitable Remainder Trust (“CRT”), described in detail under Creation of a Charitable Remainder Trust. This will allow the accounts to pass free of any estate taxes and will pay to the surviving spouse an annual income stream, either in a specified dollar amount or the lesser of the trust income or a percentage of the net fair market value of the assets.
With this option, a testamentary CRT may be established upon the death of the first of you to die. The survivor is guaranteed an annuity for his or her lifetime that will help maintain his or her lifestyle should the family’s income stream be insufficient. The property will only go to the CRT at death. It is only at death or incompetency that this aspect of your estate plan becomes irrevocable. However, even after the first death occurs, the survivor still has the ability to change which charities are to receive the assets or to bypass the CRT entirely. At the second death, the property in the CRT will pass to charity.
The final option is for you to give the accounts to charity at your death or at the death of the survivor of you. This strategy is particularly attractive if you intend to make gifts to charity at your death and the question is simply what assets should you select. As a tax-exempt entity, a qualified charity does not pay income tax and therefore receives qualified retirement plans free of income tax. In other words, if your beneficiary is in a 35% tax bracket, a $100,000 IRA is worth only $65,000 in his or her hands, but worth the full $100,000 if given to charity. Therefore, it makes economic sense to give these assets to charity and give to your children or other beneficiaries’ assets that are not subject to income tax and which receive a step-up in basis to their date-of-death value at your death.