Unlike some countries, there is no U.S. law that says you have to leave your assets or your individual retirement accounts (IRA) to a specific person. In fact, you can avoid specifying anybody as being the next owner of your IRA if you so desire. However, most people designate a person, a beneficiary, to make sure the money they’ve earned goes to the benefit of someone they care about.
Yet, if people knew more about how taxes work with beneficiaries of IRAs left in an estate, they might think twice about leaving the account to a spouse or the kids as well as a charity. Not choosing the right disposition can end up losing up to 50 percent of the worth of the account by the time it gets to the beneficiary. This loss is primarily due to two types of taxes: inheritance tax and income tax. And worse, the person leaving the money gets no say in the matter since the taxes occur after their death. As a result, estate planning is critical if you don’t want your money to end up funding Congress instead of your grandkids.
As most people know, taxes pay for government operations and re-distributing cash and assets. Irrespective of what people want in total, the federal government under current tax law will always get a piece of what is left behind monetarily. The different in how much is taken depends on how IRA beneficiaries are picked.
If the retirement money is sitting in a traditional IRA, any withdrawal will trigger taxes. This is because the money is primarily pre-tax and has not been taxed by the federal government yet. Since it generally came from payroll redirections, the government eventually wants to get what it otherwise would have taken from a normal paycheck. Eventually, federal law requires the money to come out when the owner turns 75 ½ years old. But if you die sooner than that point, it triggers transfer to a named beneficiary.
If you choose your spouse to be the first beneficiary, she or he will receive the entire 100% ownership of the account. The money can still stay in the account tax-free until the spouse reaches 75 ½ years old and the required minimum withdrawals kick in. Even if there was no named beneficiary as your spouse, in a marriage he or she will still get half of the account anyways. As long as the money is not withdrawn, then it remains tax free.
If your kids or a third person is to be the traditional IRA beneficiary, then they get hit three times. First, the government applies the inheritance tax if the IRA account along with the rest of your estate exceeds a certain dollar value ($5 million in 2011 or $10 million for a married couple). This may seem like a high number but when you add in homes, cars, accounts, assets, property, and personal belongings, an estate can total quite a bit quickly. Some states also have their own estate tax so that could add to the loss. Second, withdrawing the funds from the traditional IRA will be required, so the beneficiary has to pay taxes on the withdrawal. Finally, since the money is new to the beneficiary, it is considered taxable income and must be added to an income tax return. This applies at both the federal and state tax level. With each cut, the IRA amount becomes less and less.
The Roth IRA works a bit differently. Because the money put into a Roth IRA has already been taxes, the federal government under current law can’t tax it again. Nor can states. They both already got their share from the payroll or payment when the money was first earned. Additionally, any gains from investment while in the Roth IRA account are tax free as well. Finally, there’s no minimum withdrawal amount required at 75 ½ years of age, so an owner can build up such an account throughout a lifetime and leave the whole balance to a beneficiary.
Again, if the beneficiary is the spouse, she or he gets the entire balance and can maintain the Roth IRA account for longer if desired. No taxes are due.
Kids and third persons can receive a full Roth IRA account, but they will owe taxes on the balance. However, kids like the surviving spouse can keep the Roth account and add more deposits to it. Third persons cannot and must withdraw the funds for personal use. Kids and third persons, unfortunately, do get hit with the inheritance tax if it applies to the estate as well as income tax from both the IRS and state tax agencies. With a small IRA account, the inheritance tax may be moot, but a large account as mentioned earlier can feel a sting.
Finally, if the IRA account of either type is transferred in a trust while the owner is still alive, the tax applications work differently again. By placing the IRA account in a trust, the owner doesn’t legally own the account anymore, the trust does. Upon death, ownership then transfers to the named beneficiary. In this case, the inheritance tax may not apply but the income tax impact will still occur. However, only paying one tax is far better than paying two taxes.
Given all the twists above, it can be extremely important to map out all the possibilities for the disposition of your IRA accounts and assets and how taxes will apply in estate planning. If you’re not sure still, talk with an estate lawyer without committing to anything. The consultation will at least answer a number of legal questions as you consider possibilities. Most lawyers will provide at least one consultation for free, and estate planning legal work tends to be charged by package rather than by the hour (i.e. $300 for a will, $500 for an estate plan, $400 for a trust, etc.).
Sources:
Money Management: Inheriting an IRA!
Bankrate; You, Not the IRS, Should Benefit from an Inherited IRA; Teri Cettina; October 2004.
Fidelity: Inheriting an IRA
