If you are someone who has been financially successful enough to secure more than sufficient assets for a comfortable retirement, you may have wondered how best to achieve the goal of maximizing the value of an IRA inheritance for your loved ones, while minimizing the burden of the taxes that come along with it. This article takes a quick look at two possible approaches.
Baseline or “Current” Scenario
First, as a baseline, consider the case of someone who begins taking mandated withdrawals (“Required Minimum Distributions” or RMDs) from his or her IRA at age 70.5. If the IRA owner relies on other portfolio assets for retirement and living expenses, then assume that he or she reinvests the mandated RMDs.
This approach will leave the bulk of the IRA balance intact upon the owner’s death. So on transfer to the owner’s beneficiaries, the full tax liability remains intact as well. If the IRA owner is (for example) age 80 when he or she dies, then his or her beneficiaries will likely be in their 50s or 60s and at the peak of their career income levels. Since income taxes are due on the amount the beneficiary receives from the IRA, the inherited assets will likely be taxed at a high rate, and they may even push the beneficiary into a higher tax bracket, with correspondingly higher taxes.
On a $500,000 IRA, for example, a beneficiary in the 35% federal tax bracket would pay $175,000 in taxes, which would reduce his or her inheritance to $325,000.
Alternative One: Offsetting IRA Income Taxes
One way to avoid the $175,000 tax hit in the above scenario would be for the IRA owner to channel the mandated withdrawals into an investment designed to offset the beneficiary’s taxes at the time of inheritance. One strategy for this is to use a portion of these RMDs to help pay for a life insurance policy equal to the estimated amount of income tax that will be due upon inheritance, with the same beneficiary as the IRA. This will allow the full value of the IRA to pass to the beneficiary.
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Using the same numbers as above, the IRA owner would purchase life insurance equal to the estimated $175,000 tax liability on the inherited IRA. Upon the owner’s death, his or her beneficiary would be able to use the life insurance benefits to pay off the IRA tax liability and retain the full value of the IRA: $500,000.*
Alternative Two: Eliminating IRA Beneficiary Income Taxes
A second but similar approach to maximizing wealth transfer from an IRA is to take steps to eliminate the associated federal income taxes entirely. One way to achieve this is to name a tax-exempt charity as the IRA beneficiary. Because of their tax-exempt status, charities can receive inherited IRA funds with no tax liability at all. Again using the numbers from the initial example above, if the IRA owner’s favorite charity were the sole beneficiary, it would receive the full $500,000 value of the IRA upon inheritance.
In this scenario, for the IRA owner to pass to loved ones the equivalent value of the IRA tax free, he or she could use required withdrawals (RMDs) to help pay for a life insurance policy equal to the estimated peak value of the IRA. Upon the IRA owner’s death, the policy’s beneficiaries would then receive the equivalent amount of the full value of the IRA: $500,000.