Jamie Farmer is Managing Partner of Financial Strategies Group, a life insurance industry leader providing clients with practical solutions.
Meet John and Sally, a 70-year-old couple who own an IRA with an account balance of $1,000,000 that they don’t intend to use for retirement income. Their financial success allows them to cover living expenses without tapping into their retirement account. However, they are concerned about the taxes they will face when they take required minimum distributions, as well as the tax burden on their children if they leave the IRA as an inheritance.
Under the current rules, their two adult children will have to withdraw the IRA funds within 10 years of their parents’ passing, likely during their peak earning years, which could lead to a heavy tax hit. This can mean up to 40% in taxes, or worse—if John and Sally’s estate exceeds the federal or state tax exemption limits, their children could face an estate tax and income tax burden of 60%-70%.
But John and Sally have options, many of which could significantly reduce the tax liability for themselves and their heirs.
1. Pass Assets To Grandchildren Via An IRA Disclaimer
At death, one of the more innovative options is for their adult children to disclaim a portion of the IRA. This disclaimer would pass all or a portion of the IRA to John and Sally’s grandchildren instead of their children. While the grandchildren would still face the 10-year rule for withdrawing the IRA, they are likely in a much lower tax bracket, especially if they are still young.
To ensure the money is used responsibly, John and Sally could set up a special IRA trust, which would restrict how the funds can be used. For example, the trust could specify that the funds be used for important life expenses such as education, a first home purchase or medical care. By passing the IRA directly to their grandchildren, John and Sally can reduce the tax impact on their family while also supporting their grandchildren’s futures.
2. Set Up A Testamentary Charitable Remainder Trust
A more structured approach to mitigating taxes and protecting wealth for future generations is establishing a testamentary charitable remainder trust. John and Sally could leave the IRA to a TCRT, which would pay their children a fixed annual income (typically 5%-7%) for life. The potential benefit of this arrangement is twofold: It provides steady income to the children without immediate access to the principal, and it spreads out the tax liability over the children’s life, shielding the principal from being quickly depleted.
When the children eventually pass away, the remaining balance in the trust would be donated to a charity or a donor-advised fund of John and Sally’s choice, aligning with their charitable intentions. To replace the inheritance lost to charity, John and Sally could purchase a life insurance policy on their children. The policy’s death benefit would go to their grandchildren, ensuring that they receive their inheritance while avoiding large tax liabilities on the IRA.
3. Use IRA Distributions To Guarantee A Tax-Free Inheritance
If they intend to leave their IRA to their heirs, another effective strategy for John and Sally is to use the distributions they take from the IRA during their lifetime to buy a guaranteed life insurance policy. This insurance would be held outside their estate, and the income tax-free death benefit could be used to pay the taxes on the remaining IRA their children will inherit or simply serve as a direct inheritance for their children, tax-free. This strategy preserves the IRA’s value for charitable purposes while providing a tax-free inheritance for their heirs.
Alternatively, John and Sally could leave the IRA to charity and use the life insurance to replace that charitable gift for their children. This would preserve the IRA’s value for charitable purposes but also provide a tax-free inheritance for their heirs.
4. Make Qualified Charitable Distributions
John and Sally are charitable-minded, and they can take advantage of qualified charitable distributions once they turn 70 ½. A QCD allows IRA owners to contribute to charities from their IRA, satisfying their required minimum distributions while avoiding taxes on the distribution.
The beauty of QCDs is that they allow John and Sally to satisfy their required minimum distributions without increasing their taxable income. This is particularly useful for retirees who don’t itemize deductions but still want to support charities. Since the QCD doesn’t count as income, they can continue to take the standard deduction on their taxes, maximizing their tax efficiency while supporting causes they care about.
5. Start Taking Distributions Early
One of the simplest options is for John and Sally to start taking distributions from their IRA before they reach the required minimum distribution age of 73. By spreading out the withdrawals over several years, they can avoid larger lump-sum distributions that could push them into a higher tax bracket. This can also prevent the IRA from continuing to grow and compounding the tax problem.
It is important to start distributions from their IRA the year after partial or full retirement. This keeps the amount of taxes due each year mostly levelized, lessening the possibility of a higher tax burden in future years. Since their goal is not to use the IRA for retirement income, this strategy helps mitigate the potential tax hit for both them and their heirs.
Seek Assistance To Review Your Options
By working with a financial advisor who specializes in estate planning, you (like John and Sally) can explore these options in detail and decide on the best course of action. The right strategy can minimize taxes while making sure your wealth is passed on in a way that reflects your values and supports your family’s future.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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