Estate Planning Landmines: The IRA
Individual Retirement Accounts (IRA's) are great retirement vehicles. But they pose a danger to families doing estate planning. The danger is simple—if you handle it the wrong way, the income tax on an IRA can very quickly reach the highest tax bracket and deplete nearly 40% of the value. An IRA paid into an estate can also be subject to a 50% penalty under certain circumstances. If you want your IRA to go to your family without being depleted by taxes and penalties, read on.
A little background
An traditional IRA is a tax-deferred account, meaning that you do not pay taxes on money placed into it until the money is withdrawn. That means that the money in your IRA when you die has never been subject to income taxation. Usually the taxes are due on money that is withdrawn during the tax year when you make the withdrawal. That's all well and good if you're a person—the highest tax bracket for a person starts somewhere around $400,000 depending on how you file. So if you pay taxes on your IRA distributions, your tax rate is most likely going to be similar to what you normally pay in income tax. No problem there. Things get a bit more dicey if the money is paid into an estate.
IRA + Estate = Taxes
An IRA paid into an estate is different. An estate is a separate legal entity with its own taxpayer identification number. An estate is subject to income tax, but typically estate income is minimal. The tax brackets for an estate are much less lenient than those for an individual—you will hit the highest tax bracket (at little under 40%) if your have estate income over approximately $12,400. That is not a difficult number to hit for an IRA that has been around for any significant period of time. For tax purposes, paying an IRA into an estate is probably the worst-case scenario.
IRA + Estate + Time = Penalties (Sometimes)
Some of you may be thinking "that's ok, I'll just write in my will that the payment should be spread out over a bunch of years" and that doing that would decrease tax liability. It's a smart idea in theory, but in practice it could cause a mountain of pain. You see, an IRA paid into an estate (meaning no beneficiaries or the estate as a beneficiary) before the account holder reached age 70 1/2 is subject to the five year rule for distributions. If you stretch an IRA inherited by an estate beyond the five year cutoff, the penalties are severe.
The Five Year Rule
The "five year rule" applies to IRA accounts distributed to an estate either as a beneficiary or when an IRA has no beneficiary and the agreement directs payment into an estate. If the person who died was over 70.5 years old, they estate beneficiaries can "stretch" the distributions. But for our purposes, assume that the person who died is under 70.5 years old. In that case, all of the IRA money must be distributed into the estate within five years of death. Miss that five year cutoff? The penalty is 50% of the amount you should have distributed. You can ask the IRS to waive the penalty, but do you really want to rely on the goodwill and charity of the IRS?
So let's say you left $100,000 in an IRA without a beneficiary. That money would go be paid into your estate and the estate income tax brackets would apply. Under the 2016 code (and without factoring in any deductions), the taxes owned would be approximately $37,900. That leaves $62,100 for your heirs. Now let's suppose that for some reason the IRA is not distributed within five years of death. The penalty is an even $50,000 because all $100,000 should have been distributed within give years. Of the $100,000 in the IRA, you're left with approximately $12,100.
What Can I Do?
Simple. Make sure your IRA's all have beneficiaries that are living, breathing, human beings. A spouse is preferred because they have the most options for dealing with the IRA but a child, other family member, or friend will work in a pinch. The worst case scenario from a tax perspective is to direct the money into your estate.
Smart estate planning can make a world of difference. Or, in the example above, $87,900 of difference.