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Introduced in 1975, Individual Retirement Accounts (IRAs) initially allowed individuals to contribute up to $1,500 to a tax-deferred account. Three years later, 401k plans were adopted, then overhauled in 1986 to allow maximum employee contributions of $7,000. Back then, it was hard to imagine an IRA or 401k account reaching $1,000,000, yet today many families’ accounts exceed that figure.
When a tax-deferred account owner dies, the value is transferred to a new owner via a beneficiary document. Tax-deferred accounts are not included in the decedent’s last will and testament unless the beneficiary is unnamed, has already passed, or the deceased specifically directed such accounts to the estate.
There are three types of IRA beneficiaries: spouses, non-spouses and charities. The spouse is the only beneficiary who can roll the asset into their name thus using their age for withdrawal rules and Required Minimum Distribution (RMD) calculations. Non-spouse beneficiaries (typically a child) must begin taking RMD’s regardless of their age, even if they are a minor. Charitable beneficiaries pay no income tax and may use the funds as they choose.
When individuals planning to leave tax-deferred accounts to their children or grandchildren do not consider tax rules applying to RMD’s, excess taxation can result. The idea that a grandparent or great grandparent could pass assets on via the “stretch” – a term describing a beneficiary who holds assets in an IRA or even a Roth IRA with withdrawals coming out over the beneficiary’s life expectancy – may sound very tempting. But it is important to understand the entire tax code and not just the parts you like!
Recently, a widowed great grandfather planned to leave his IRA exceeding $1,000,000 to his both of his four year-old great-grandsons. Under current tax code rules, the boys would be able to withdraw the money out of the account over their life expectancy. If the great-grandfather passed away today, each four year-old grandson would have to withdraw approximately $6,350, with annual withdrawals increasing incrementally. This sounds like a small taxable amount, except that the Kiddie Tax applies, taxing a child’s interest, dividends and capital gains at the same marginal tax rate as the child’s parents.
The great-grandfather recognized his son and grandson didn’t need the money and there were other assets involved. The elders assumed the boys would be in the lowest tax bracket as non-income earners and they were correct – for the first $2,100. The problem is that inherited IRA RMD’s are subject to Kiddie Tax rates. Any funds above $2,100 of non-earned income is taxed at the parents’ (both surgeons at the 39.6% marginal tax rate) marginal tax rate. The great-grandfather was actually in a lower tax bracket than his great grandsons.
Planning can go afoul when people understand only part of the tax code. The attorney wasn’t wrong in designating the kids as beneficiaries. However, viewed through the lens of tax code rules, other options such as a Roth conversion or other assets could potentially provide the kids with tax-free income.
Tax advice provided by CPA’s affiliated with Financial Enhancement Group, LLC.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column offset=”vc_hidden-lg vc_hidden-md vc_hidden-sm”][vc_widget_sidebar sidebar_id=”sidebar-main”][/vc_column][/vc_row]