IRAs and Estate Planning

When you start your career in life planning and wealth management you realize every day is like drinking from a fire hose. As time goes on…it doesn’t really change. Unfortunately, there is ever increasing complexity that surrounds what seems to be the simplest of planning tools. IRAs, 401(k)s, and other like-kind retirement accounts are a prime example of this.
The simplicity is that these are savings tools for retirement! Originally, theses were designed so you could put back dollars before they were taxed and allow those dollars to grow tax deferred until you retired. Furthermore, it used to be commonly thought that you would most likely pay lower taxes during your retirement years. So, this meant that paying tax on the money you take out in retirement was probably not going to be a big deal. Then, if your retirement dollars outlived you and your spouse, you children would have the opportunity to stretch what was left over their lifetimes. Not bad at all, right?
The reality today is that it simply isn’t that simple anymore. That opportunity to stretch what is left over their lifetimes doesn’t exist…at least not in the traditional fashion. What exists today is an extremely complex set of rules and very little time to distribute the IRA in full.
Why is this important?
Many people are concerned with their children paying estate taxes. The funny thing is that they don’t ask about their children paying income taxes. If you ask me, taxes are taxes no matter what category they fall in. And truth be told, there are a lot more people that should be concerned about what their children will pay in income taxes after they die than estate taxes.
In June of this year, US retirement assets totaled $40.0 trillion!1 Imagine that these dollars were taxed at 10% – that is $4 trillion in INCOME TAXES. The average income tax rate in 2021, which was just compiled for studies this year was 14.9%.2 So, if taxes remain the same and your heirs are average tax payers, this moves the needle on these retirement assets to almost $6 trillion of income taxes. But wait…this gets a little scarier.
We are on a progressive tax schedule in the US, which means higher income levels will result in a higher tax bracket. If you couple this with the fact that your heirs will only have five to ten years to distribute a retirement account in full, there is a good chance that they could see a lot higher rate than 14.9%!
Imagine a $1 million dollar retirement account that needs to be distributed over five years to your estate. This could be $200,000 of additional, taxable income added to a tax return for each of those five years. The question is how much tax will that incur? 22%, 24%, or higher?
Now that we have that out of the way, let’s talk about the complicated part – the timing!
Depending on who you have named as beneficiary(ies) and how old you are when you die will determine the rules around when said beneficiary(ies) will need to start distributing money out of your IRA. I will try to simplify this part as much as possible.
- If you are taking Required Minimum Distributions when you die, then most likely the next generation will need to continue these. If you are not, then they won’t.
- If you leave your IRA to your “estate” or a trust (in many cases), your heirs will most likely only have 5 years to distribute the IRA in full.
- If you leave you IRA to a named child beneficiary or child beneficiary, they will most likely have 10 years to distribute the IRA in full.
You may notice the words “most likely” a lot in this article! It is critical to note that there are technicalities around each of these that will not be mentioned here. You really need to be working with a professional who understands the rules very clearly.
In the spirit of Estate Planning Awareness Month, you need to be aware of the implications of your retirement dollars when you die. And…if you don’t like it, the good news is that you are breathing. There still may be time to do something about it. And, yes, we can help with that…just don’t wait until it is too late!