Estate Planning 201 – Best Practices for Bequesting Retirement Accounts

How would you feel if the IRA you contributed to over your working lifetime was 70 percent consumed by taxes once you have passed away?

Estate planning focuses on passing assets efficiently to beneficiaries, and much of this planning deals with mitigating income and estate tax. Taxable estate assets are those assets in excess of the $5.43 million exempted amount for 2015, and are taxed at 40 percent, excluding assets left to a spouse or charity.

For example, a $100,000 IRA as part of your estate above the exemption amount effectively becomes a $60,000 inheritance if left to your niece, Betty. Betty, a neurosurgeon living in California, is required to take distributions and is taxed at her ordinary income tax rate, which is 39.6 percent at the federal level and approximately 10 percent at the state level. So her $60,000 IRA inheritance will be further cut in half by income taxes. And that’s how only 30 cents of each dollar of this asset actually passes to your heirs.

It is possible, however, to avoid this 70 percent attrition of retirement assets at death. Let’s look at some of the best practices to bequest retirement accounts more tax efficiently.

  1. Reduce assets held in your estate: While you can’t relocate your IRA outside of your estate, there are plenty of strategies you can implement to reduce your taxable estate. Assets that can be relocated outside one’s estate include investment securities, insurance, real estate and partnerships, to name a few. Work with your CERTIFIED FINANCIAL PLANNER™ professional and advanced estate planner to consider a lifetime gifting strategy or to set up trusts for your family that that hold assets outside of your estate. Taxpayers with high incomes should consider these strategies now. Who knows what the exempted amount will be 40 years from now for a couple in their 50’s today.
  2. Roth conversion: If your income is low in a particular year, consider doing a Roth conversion. This will reduce your estate by the amount of tax paid, and eliminates the income tax your beneficiary will pay.
  3. Donate to charity: In nearly all recent years, Congress has approved the “charitable rollover” which allows those aged 70.5 or older to give up to $100,000 directly to charity. Choosing a charity as a beneficiary also removes the donation from the taxable estate so no estate tax will be owed.
  4. Choose a beneficiary in a low tax bracket: Specifically allocating various assets in your estate, like the taxable IRA, can be more tax efficient. For example, your nephew Jorge, a school teacher in Florida, enjoys a 25 percent federal income tax rate and no state income tax – half of what niece Betty received in the example above.
  5. Choose a young beneficiary: Under current law, beneficiaries are allowed to stretch an inherited IRA over their expected lifetime, lessening the required amount they must take each year. Choosing a younger beneficiary means that the IRA can enjoy its tax deferred – or tax-free – status for a Roth IRA longer.

To minimize the estate and income tax bite of retirement assets, it’s important to design an estate plan to take advantage of these strategies.