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Avoiding the Worst of Both Worlds

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A central issue for many older clients is preserving IRA assets from estate taxes. Michael T. Koenig, managing partner at FirsTrust in Daytona Beach, Florida, offers the following tips:

The IRA rules have changed in recent years, and broader opportunities have arisen which permit us to incorporate large IRAs into an estate plan in a more tax-efficient manner. Historically, since we have an unlimited estate tax deduction on qualified property that passes to a spouse, IRAs have most often been rolled over by the surviving spouse without receiving the benefit of the decedent’s estate tax exemption. This eventually left the IRA exposed to estate taxes in the spouse’s estate. The rules changed a few years ago to permit a properly structured trust to serve as the “designated beneficiary” of an IRA in order to help mitigate this problem. But this solution is not absolute and can be accompanied by a variety of devastating tax downsides if, as many people have, they simply name their revocable living trust as the IRA beneficiary.

Another common mistake is to assume that all inherited property is tax-free. Income taxes may still be due on certain items that are taxed as Income in Respect of a Decedent (IRD), of which IRAs are the most typical. Statistics tell us that as much as 70% to 80% of an inherited IRA can be depleted by a combination of federal and/or state estate and income taxes–even after the application of the tax credit afforded under Code Section 691(c).

Since IRD assets receive no step-up in cost basis at the owner’s death, a federal estate tax is assessed on the entire IRA, even the portion that the beneficiaries will then hand over in federal and state income taxes.

The only thing worse than paying a tax is paying a tax on the money you pay taxes with.

Think about it: if you cashed in a $1 million IRA on the day before your death and paid 40% of it in income taxes, federal estate taxes would only be assessed on the remaining $600,000. But if you died owning the entire IRA, the entire $1 million would be subject to federal estate taxes before another 40% is lost to income taxes. It’s the worst of both worlds.