Are Retirement Accounts Included in Your Estate? Surprising Answer

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Paul Sundin, CPA

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Having large retirement accounts, and mainly Individual Retirement Accounts (IRAs), 401-K’s, and Tax Sheltered Annuities can not only ensure your comfortable retirement but provide bright financial perspectives for your heirs in case of your death.

However, those accounts are subjects for:

  • Income tax at death;
  • Estate tax at death;
  • Generation-skipping Taxes (GTS).

In fact, retirement accounts, and particularly the large ones, are the most heavily taxed assets. In most cases, it leads to the fact that the beneficiary of those assets gets as little as 15%-30% of the original sum due to tax deductions.

That is why comprehensive and qualified management of your income and estate planning can preserve the inheritance you plan to leave your beloved ones and even multiply it.

Qualified Retirement Plans

This same issue—the importance of beneficiary designations in the estate plan—is also seen in
qualified retirement plans, 401 (k) plans, and IRAs. The disposition of these assets is not governed
by the will (or will and revocable trust). Rather the disposition of these assets is governed by the
beneficiary designation.

For these qualified plan assets, income tax considerations must be addressed. If a qualified plan asset
is withdrawn, it is considered a “distribution” and triggers the income tax. However, if the qualified
plan assets are paid to the surviving spouse as the named beneficiary, then there may be no income
tax due. If the qualified plan assets are paid to a beneficiary other than the surviving spouse, income
tax is due (although in some cases it may be deferred).

Stated differently, Qualified Retirement Plans, 401(k)s and IRAs are all eligible for a spousal
rollover. They should not be used to fund the Credit Shelter Trust. The estate planner should verify
that the beneficiary of these types of plans is the surviving spouse. The goal is to defer the payment
of income taxes on the plans for as long as possible.

If any other beneficiary, such as the estate or a trust or children, is named as beneficiary of these
types of plans, then at the time of death the income tax has to be paid on the entire amount in these
plans and the chance to obtain the deferral of the income tax is lost.

Generally the estate of the plan participant, or a revocable living trust set up by the participant is
named as the contingent beneficiary if the spouse does not survive the participant.

Principles of Tax Imposition for Retirement accounts

Depending on the retirement account’s size, character, and even the nature of the relationship between the testator and heir, the assets can become subject to numerous taxes that can shrink the final spendable after-tax significantly.

Let’s go over the fundamental tax regulations for large retirement accounts:

  • The Income Tax. Technically, in case of the testator’s death, the beneficiary receives the assets at relevant value. In case the beneficiary decides to sell those assets, there will be minor income tax consequences. However, Retirement Accounts belong to a particular class of assets named Income in Respect of a Decedent (IRD). It makes them subject to federal income tax and state income tax at the account owner’s death. And those are only the two most significant out of six taxes applicable for such assets.
  • Estate Tax. Depending on the size of the owner’s estate, state and federal estate taxes may become applicable for the retirement asset. This kind of taxation considers all decedent’s assets such as real estate, retirement accounts, stock bonds, etc. Today the federal estate tax is 40%. As for the state estate tax, its imposition depends entirely on the assets` location. By now, 12 states, including California, don’t impose state estate and inheritance taxes.
  • GTS Tax. Suppose the beneficiary of the inheritance is more than one generation younger than the testator, or he or she is an entirely unrelated person who is more than thirty-seven and a half years younger. In that case, the assets become subject to Generation-Skipping Transfer Taxes (GTS). Leaving IRAs, 401-K’s, and other retirement assets to grandchildren is a perfect way to postpone taxation for as long as possible. However, if we are talking about large retirement accounts, this decision may end up in an additional 40% tax on top of the taxes that would have to be paid.

Principles and effect of Tax-Deferred Compounding

The principle of Tax-Deferred Compounding is based on the so-called “Rule of 72” familiar to all investors. It is a simple formula that determines how long it’ll take for an investment to double, based on its rate of return.

This rule applies to anything that grows at a compounded rate, including the IRA.

The formula is:

Years to Double = 72/Interest rate

It means that at a 10% return, the money doubles in approximately 7 years. In other words, with such Interest Rate, a $1 million IRA would be worth about $4 million in 14 years.

Of course, considering today’s economy, the 10% rate might seem pretty unrealistic. However, even now, such rates are pretty applicable for real estate.

According to this principle, if we take a couple, where one of the spouses has an IRA of $500,000, and they wish to defer taxation of the IRA and eventually distribute it to their grandchild, with all the standard withdraws and an introductory 6% growth rate, IRA would be worth around $577,342 after 15 years.

If, in case of one spouse’s death, the second one engages in a “spousal rollover,” they leave the IRA to a special trust for the grandchild’s benefit. It allows the IRA to continue to grow tax-deferred for the most extended period possible. Suppose the grandchild lives another 54 years (648 months); over that period, he or she can get a total of about $4 million.

Using this principle, comprehensive and qualified Estate Management allows you to ensure a brighter future for your heirs.

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Estate CPA

Gilbert, AZ