Taxes are going up!!
If you Google those words, you will find myriad sources saying just that, and some of the reasons why include:
• Washington acknowledges that the 10-year deficit will be more than $9 trillion—greater than all previous federal deficits combined. As we come out of a recession, Congress will need to reduce the deficit.
• Projections on the 10-year cost of any final health care bill range from $600 billion to more than $1.1 trillion.
• State budgets are in dire straits, with 48 states reporting budget deficits. There will be growing pressure to provide federal money to help support the state programs.
Bottom line, your clients may be passing a significant and costly tax burden on to their beneficiaries by not properly planning for the distribution of their IRAs. According to a January 2007 report by the Employee Benefits Research Institute, more than $3.6 trillion are invested in IRAs! Chances are your clients have a share in that total; and if they do not plan properly, they will give the government more than its fair share.
You need to make your clients aware that if they pass their IRA directly to their beneficiary(ies) in a lump sum, the result might be income taxes on the entire IRA amount. Such taxation could erode the IRA’s value more than one-fourth to one-third at today’s tax rates. Can you imagine what the result could be in 10 years?
What Can You Do to Help?
There is an alternative that can enhance the value of the legacy your client has created and wishes to pass on. Let’s first look at a typical IRA distribution. Many IRA owners designate their spouse as beneficiary and then their children. The surviving spouse will receive the IRA balance upon the death of the owner and be able to roll it into his/her own account, allowing continued deferral of taxes and the minimum required distributions as mandated. Typically, the children will then be named beneficiaries.
When the children inherit the IRA, their maximum deferral is based on their ages at that time. If a child dies prior to the end of the maximum deferral period, the grandchildren inherit the balance of the funds plus the remaining balance of their parent’s maximum deferral period. This could mean an extremely short deferral period before the grandchildren have to pay tax on the remaining IRA. Let’s take a look at the effect of this in Chart 1. Note that although the surviving spouse and children could defer taxes on the IRA, the grandchildren are stuck with an excessive tax liability.
There Is a Better Way!
By just making some minor changes to your client’s current IRA planning, their legacy can be passed on to several generations. The key in the planning is to maximize the tax deferral. How is this done? The surviving spouse would name the grandchildren beneficiaries of the IRA rather than the children. Then the grandchildren’s life expectancies would be used in the tax deferral. See Chart 2.
Your first question might be: Are the parents actually going to disinherit their children? The answer is no, and this is where your opportunity lies. Simply have them replace the children’s IRA inheritance with a life insurance policy. Among the advantages to using life insurance is that the children receive the death benefit tax free.
Here are the results of this simple change in the parents’ planning:
• Their children receive the life insurance proceeds (the maximum projected value) as their inheritance, income tax free.
• Their grandchildren receive the IRA as an inheritance and are able to defer the taxes over their life expectancy, taking the minimum distribution each year. Because of their younger age, their tax-deferral advantages continue much longer. Of course, this should be done via a trust.
You’re probably thinking that this approach sounds good so far, but what about the underwriting for the life insurance policy? Plus, how are the parents going to pay for the premiums? True, this approach will work only if both parents are insurable. Though in some cases, a second-to-die policy might solve the problem of an uninsurable risk. If a client is over age 70, required yearly distributions from their IRA could be used to pay premiums. If the client is under age 70 but over age 591/2, distributions could be taken from their IRA to cover premiums, provided there are no other penalties involved.
As you can see, with just minor changes to your client’s IRA planning, they can significantly improve the performance of their IRA for generations to come.
These illustrations provide a broad, general guideline about IRA distribution. Calculations in the above illustrations are estimates. For tax or legal advice, have your client contact a legal or tax advisor.
