Individual Retirement Accounts (IRAs) and qualified retirement plans are designed to encourage saving for retirement during your working years. Contributions are generally tax deductible and assets grow tax-deferred.
But because assets can grow quickly, they sometimes far exceed the needs of their owners and become inheritance plans.
While the plans are great ideas, they can create significant estate planning problems with a dramatic tax impact. Retirement plans can be bad assets when they end up in an estate, because combined federal, state and estate taxes can consume up to 75 percent of the value of these assets, leaving a fraction for heirs.
Given the virtual certainty that tens of thousands of people will pass away with large retirement plan balances, the need for strategies is extremely high.
First, list your assets and liabilities to determine the net value of the estate in current dollars. The investment assets should be categorized as either retirement plan assets (IRAs and qualified retirement plans) or nonretirement plan assets, those held in taxable accounts. This allows you to determine a hypothetical estate tax.
Next, review the beneficiary designations for each retirement plan account. Keep in mind that assets held in retirement plans pass to the named beneficiaries under contract law regardless what any will might provide.
One way to stretch out the income taxes to be paid by the beneficiaries as they receive distributions from inherited IRAs is to use a multigeneration or stretch IRA. Heres how it works: When the plan participant dies, the surviving spouse, as the beneficiary, rolls the proceeds into different IRAs, each one with a child, grandchild or charity as the sole beneficiary.
When the surviving spouse reaches age 70-1/2, required minimum distributions must be made from each IRA. However, the distribution period is calculated based on the joint age of the spouse and beneficiary (maximum l0-year differential). When the surviving spouse dies, the distribution period is recalculated based on the beneficiarys life expectancy.
While the multigeneration or stretch IRA allows the IRA to continue to grow tax-deferred, it does not reduce the estate taxes due or replace the wealth lost to income and estate taxes. It simply defers the payment of the income taxes due on the distributions from the IRA.
If you want to replace the wealth lost to taxes, consider an irrevocable life insurance trust (ILIT). If the ILIT is properly drafted and managed, it will result in significant insurance policy death proceeds distributed to family, both income and estate tax-free.
A second-to-die life insurance policy, usually a universal life policy, is acquired by the ILIT. The beneficiaries of the ILIT can be children or grandchildren. Annual distributions are made from an IRA or qualified plan in an amount sufficient to pay the income tax due on the withdrawal and to fund a gift to the trust equal to the annual insurance premium due. This gift qualifies for the annual gift tax exemption.
Upon the death of the insured, the death proceeds are paid to the trust, which in turn distributes the proceeds to the beneficiaries of the trust, free of any estate or income tax. In effect, the death proceeds from the insurance policy replace the reduction in value of the decedents estate due to estate and/or income taxes.
This is an effective means of bypassing the estate and transferring wealth to ones heirs.
There are many other ways as well, and any financial investment consultant can outline which may work for your situation. The bottom line is this: It is important to recognize the potential problems inherent in retirement plans and take the steps necessary to preserve the wealth that has been accumulated in these plans. The method you choose is up to you.
Arthur Weisman is an investment consultant with First Union Securities. He can be reached at (216) 574-7317.