Some people, because of the wealth they have accumulated, won’t have to rely on their retirement plan savings for retirement income. As a result, they often want to leave all or most their IRA (or 401(k) and other retirement plan assets) accounts to their heirs.
Tax darling now, tax bomb later
These retirement plans are tax-efficient accumulation vehicles during lifetime. You get a tax deduction for contributions and the growth and earnings in the plan are not immediately taxed.
But, as a wealth transfer mechanism, they are quite tax-heavy. The intended beneficiaries of the plans may lose up to 70% of the account balance to estate and income tax and end up with very little of these assets.
That’s right, income tax. Not only might there be an estate tax to be paid, but income tax on the distributions as well.
No basis step-up, double the tax bill
Here’s how it works.
When you die, most of your assets receive a basis step-up to the fair market value as of the date of death. In practical terms, this means that any built-in gains that you would have paid income tax on disappear forever. Your beneficiaries start with a fresh cost basis.
Said differently, if your heirs were to sell the inherited assets the day after you die, they will not recognize any gain or loss. That’s because the sale price and the basis are the same.
Let’s say that you own a rental house. You paid $100,000 for it and now it’s worth $1 million. Ordinarily, if you sell it, you will realize a gain of $900,000, and you owe income tax on the gain. But, if you hold on to the house until you die, and your heirs sell it for $1 million, there will be no gain. It’s because the basis gets stepped up to the fair market value ($1 million). So, $1 million minus $1 million is zero. It doesn’t matter that you actually paid $100,000 for the house.
That’s the good news. The bad news is that the basis step-up rules do not apply to IRAs. With this type of asset, any untaxed income tucked away in the plan follows you to your grave. Any distribution from these retirement plans after your death is subject to income tax as ordinary income at the beneficiary’s income tax bracket.
The power of tax deferral
Generally speaking, your non-spouse IRA beneficiaries must make distributions over 10 years, and empty it out by the end of 10 years.
Let’s assume you are 50 and currently have $500,000 in your IRA growing at 7% per year, and you’re making no additional contributions. It will grow to slightly above $2 million by the time you’re 71. Then at age 72, you begin taking required minimum distributions.
If you die at age 85 when your spouse is 81. Your spouse then takes required minimum distributions until their death at age 85. The IRA at their death will shy of $2,680,000.
Your 56 year-old daughter and 54 year-old son inherit the IRA from your spouse and continue to take distributions systematically over the next 10 years.
In the final analysis, the four of you will have milked over $6.5 million out of the plan over nearly three decades. Your children alone would end up taking over $4.1 million. Not bad for what started as a $500,000 account.
That’s the power of stretching out income tax liability as far as you can with a tax-deferred vehicle.
No cash to pay the estate tax
But what if, when your spouse dies, there is estate tax due. And the estate is made up of assets that can’t be readily converted to cash – like real estate or business? How would your children come up with the money to pay the estate tax?
One highly likely possibility is that your daughter and son will be forced to liquidate the IRA to meet the estate tax obligations.
Now, remember, in addition to the estate tax, there is income tax on the distribution. The total potential income and estate tax burden would be about 62%. The net amount your daughter and son are left with is only 38% of the $2,680,000 balance at your spouse’s death. That’s only about $1,041,000.
(For those who are technically inclined, you get a deduction for any estate tax attributable to the IRA balance. So with the top estate and income rates of 40% and 37% respectively, the total tax rate doesn’t add up to 77%. Whew!)
As mentioned, the economic advantage of stretching out your retirement plan assets as long as possible is enormous—if you can help it. But the reality is that your estate may not be that liquid, and the temptation is to tap into the IRA money to meet estate tax obligations.
Buy money with cheaper money
But, you say, if I don’t want my heirs to touch my IRA, but instead, stretch it for the maximum 10 years to take advantage of tax-deferred growth, how do they come up with the cash to pay the estate tax?
Glad you asked. The answer: life insurance. Life insurance sort of allows you to “buy money with cheaper money.” For example, about $80,000 of annual payment buys a $5 million guaranteed death benefit on a second-to-die policy for a relatively healthy 65 year-old male and a 61 year-old female.
Is the $80,000 annual premium expensive? That’s for you to decide. But the question you should be asking is, “Expensive compared to what?” After 25 years (not far from the joint life expectancy), the cumulative premium paid will have been $2,000,000. Your heirs will receive $5,000,000. So $2,000,000 will gets you a guaranteed $5,000,000 death benefit.
For the analytical types, if you translate this into a rate of return, it’s 6.48%. But wait, since the death benefit is not taxable, the tax equivalent return at 37% tax rate is 10.28%. If you structure policy ownership so a third party owns the policy (a trust, for example), the death benefit escapes estate tax, too. In the above example, the effective tax rate was 62%. Using that rate, the tax equivalent rate of return would be 17.05%.
So, is guaranteed 6.48% (or 10.28% or 17.05%) a good rate of return? Again, it’s for you to decide.
Moral of the story
At any rate, here is the moral of the story:
One final note: these rules pertain to “traditional” IRAs. Rules are different for Roth IRAs. But that’s a topic for another day.
There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Investors should talk to their financial advisor prior to making any investment decision. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.