Reducing taxes on IRA distributions during life or deathArticle added by Steve Savant on January 9, 2012
Steve Savant

Steve Savant

Scottsdale , AZ

Joined: January 28, 2005

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During life, the IRA holder is forced to distribute required minimum distributions at age 70½. Interestingly enough, there is no talk on extending the RMD distribution age, even in the light of discussions about extending the Social Security age. Here’s a list of options to mitigate these taxes and a quick review on each.

How can this still be happening?

A child is receiving a $500,000 distribution from a parent’s IRA and paying $200,000 in income taxes. This is middle class estate tax. Okay, not estate tax, but taxes resulting from the transfer of the parent’s estate to their children. The estate of the parents may not be large enough to pay estate taxes, so it flies under the radar of estate tax attorneys and financial advisors.

No fiduciary advice? Then the kids pay income taxes on the receipt of the IRA proceeds at death. Throw in the state tax on estate transfers and you have a real double-tax tragedy. And if the estate is large enough for federal estate taxation, which could be a distinct possibility in 2013, you could have triple indemnity.

Whether it’s income tax, state transfer tax or estate tax, it’s a preventable financial fiasco.

During life, the IRA holder is forced to distribute required minimum distributions at age 70½. Interestingly enough, there is no talk on extending the RMD distribution age, even in the light of discussions about extending the Social Security age. Here’s a list of options to mitigate these taxes and a quick review on each.
  • Make sure the IRA has a non-spouse, individual, designated beneficiary named on the IRA account in case there is no surviving spouse at death. This allows the beneficiary to take the money over their lifetime.

  • Give away the RMDs while living or the IRA at death to a charity and replace the IRA money with a wealth replacement trust.

  • Use part of the RMDs to buy a life insurance policy to replace the money paid in taxes on lifetime distributions, and leave the proceeds to the kids, grandkids or charity, providing the owner is insurable.

  • Convert the IRA to a Roth IRA once you’ve established the economic viability.
Stretching out the taxation of IRA distribution at death

This is such a simple and easy strategy to explain to clients. Most married couples leave their IRAs to each other. And of course there is no estate tax or income tax on money left to a surviving spouse. If there is no living designated beneficiary at death then the non-spouse beneficiary must pay income taxes on it in the year it is received.
The alternative: The IRA owner selects an alternative beneficiary other than their spouse. That person then has the ability to take the entire amount in one lump sum and pay full taxes, or re-register the IRA in a way that they control the account for their own benefit and just take RMDs based on their then attained age over their lifetime.

This preserves the ability to continue deferring taxation on growth of the account in excess of the RMDs. If the child chooses to take more out then required, they can if they are willing to pay the taxes.

Please make sure all of your clients who care about their kids finish the simple task of naming a secondary beneficiary on all their IRA accounts.

Converting IRAs to Roth IRAs

This was a hot topic in 2010, when the rules for conversion were liberalized, and the taxes could be spread over two years on the conversion. The results were lackluster. The concept was too complex for most people to deal with. The numerous variables in the assumptions made advising clients difficult.

Minor changes in variables could greatly change the results of the projections, making them unusable. The best outcomes required money outside the IRA to pay the income taxes at conversion; people hate to pay taxes early and many just did not have this cash lying around. However, with all that said, if you choose to let your IRA grow and intend to leave it to the kids, the conversion may be a good idea for several reasons.

Many people expect tax rates to increase in the future. If you believe that, then paying taxes at a lower rate now and avoiding higher future income taxes makes sense. There is no 70½ RMD requirement on Roth IRAs, so it can grow without current or future income taxes. Roth IRA rules do require the heirs to make an RMD based on their attained age, but they can stretch the payments over their lifetime.

For estates subject to estate taxes, the early payment of income taxes on the conversion reduces the size of the estate subject to estate taxes. In effect, the reduction of estate taxes helps offset the cost of the income tax on the IRA conversion.

Gifts of IRAs to charities

This is a very simple strategy. IRA money left to charities avoids estate taxes and income taxes at death. The gift is a deduction against the estate for estate tax purposes. The money received by the charity is not subject to income tax because they are non-profits (for purposes of this article, the author assumes all gifts are to qualified charities for IRS purposes).

Read on to understand how the kids can be made whole after the gift to charity using a wealth replacement trust.
Leaving RMDs to charities is more complex. The donor needs to have enough adjusted gross income to be able to deduct the gift to charity. If not deductible this year, it can be carried over as a deduction for up to five years. And, as always, the donor should have their tax advisor run it through tax projection software to verify the actual tax benefit that is likely to be achieved.

Here's an example of how a distribution from an IRA coupled with a gift to charity can cause adverse tax consequences. The IRA distribution increases adjusted gross income and then the charitable deduction gets deducted on page two, after AGI is determined.

This higher AGI could cause limits on medical expenses being deducted and/or increase the amount of Social Security income that is subject to tax. The result could be that the benefit from the charitable deduction would be significantly diminished by the increased AGI reducing tax deductions or causing an increase in taxable income. There is no such thing as a quick mental calculation anymore; if you try it, you are mental.

Using life insurance to save the day

The first solution addressed leaving IRAs to charity. However, many donors want to leave the IRA to their heirs. One solution is to create a wealth replacement trust.

In this strategy, the donor takes money from assets other than the IRA to fund a life insurance policy to replace the gift made to charity. The income and/or estate taxes are avoided on the IRA at death. The life insurance is paid to the trust, income and estate tax free.

This may all be counterintuitive. How can you give money away and still take care of the donor and their families during life and at death?

The proof is in the pudding. In the cases I have worked on, the net effect is to substantially reduce estate taxes and income taxes, while providing some very large gifts to charity. The client maintains their lifestyle and still takes care of the kids while creating a large gift to the charity.

This works best when the estate is large enough to pay estate taxes because the tax relief is larger. However, it still works well when there is no estate tax because of the income taxes on the IRA to heirs at death.

A way to demonstrate the effects of this planning on the donor, the heirs and the charity, is to use the Wealthy and Wise software from Insmark or other supporting software. The key is to show the impact on their living standard and that the kids will be taken care of at death. The potentially large gift at death to a favorite charity makes us all feel good; kind of like whipped cream on top of our chocolate.

Before proceeding with any of these ideas, make sure you employ a competent tax advisor, tax attorney and possibly life insurance professional to determine if or how this may make sense for you or your clients.
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