This is the first installment in a series that will be printed in this newsletter every third edition to describe the options and details for establishing an estate plan by the owner of these accounts.
IRAs and employer sponsored retirement accounts (i.e., 401K, 403b, etc.) often hold a substantial portion of an individual’s savings upon death. Since the earnings deposited into these accounts, including accrued interest and dividends, are often untaxed or have only been partially taxed, the burden for taxation will ultimately pass to the beneficiary receiving the account. If there is a state or federal estate tax due, then the estate would also pay an estate tax on those funds. It is important to understand how the taxes and account transfers operate in order to properly plan.
Estate taxes
These days, the estate tax is often the least burdensome tax to consider for planning purposes due to credits and exemptions. Every decedent who is an American citizen has a $5.34 million unified lifetime estate and gift tax exemption in 2014. Since few estates reach this total value, even when including lifetime gifts in excess of the annual exclusion, it is not a significant planning concern for most individuals or couples. Massachusetts still has only a $1 million estate tax credit exemption, although there is no federal or Massachusetts estate tax whatsoever for an inheritance of any amount by a surviving spouse who is an American citizen.
Individual taxes
However, the individual or individuals named as beneficiaries of an IRA or retirement account, including a spouse, will pay income taxes on the (previously untaxed) funds as they are distributed from the account. Roth IRAs are the exception, and do not have any federal income tax on “qualified” distributions because they have been previously taxed. The tax rate will be based on the amount that that the beneficiary would pay as work earnings the year of distribution.
Avoiding excessive taxes
This brings up the consideration of whether parents and other individuals with poor health and perhaps a limited life expectancy should make greater than minimum distributions during their lifetimes. They might be paying taxes at a substantially lower rate or have more medical care income tax deductions than the beneficiary who would otherwise inherit the account. The opposite consideration is the more traditional practice of leaving the funds in the IRA or retirement account without paying the taxes until absolutely necessary to maximize the investment growth potential of the account.
Beneficiaries of an IRA or retirement account are usually spouses, children, or other individuals, but trusts including a special needs trust, charities, and other non-person entities can also be named. However, the rules for properly naming a beneficiary without causing an immediate taxable distribution are complex, and expert advice should be obtained particularly for non-individual beneficiaries in order to prevent unintended distributions in a shortened time period that creates an excessive tax. The owner can also name successor beneficiaries if the intended beneficiary dies before the owner.
There are many specific rules for maintaining the greatest tax advantage for inherited IRAs and retirement accounts, and I again emphasize the necessity for expert advice and reviewing the details of each particular retirement account plan when naming the beneficiary.
Neal Winston is the principal of Winston Law Group, a Boston law firm specializing in estate planning, probate, special needs planning, elder and disability law. A nationally recognized expert on special needs counseling and trusts, and public benefit programs, Neal is frequently requested to lecture and train other attorneys and professionals that work in this field.