For many families, an individual retirement account can be their largest investment asset and in many situations will be the primary source of income during retirement. Employers have abandoned the retirement pension system prevalent in the early part of the last century and have adopted 401(k) plans that permit deposit of employee deferrals as well as employer contributions. 401(k) plans have similarities to IRA’s and upon retirement, many employees will roll their 401(k) plan balance to an IRA. For this reason, this discussion will focus on just IRAs.
The great advantage of IRAs is the deferral of income tax. Original contributions to a traditional IRA are tax deductible and the investment earnings inside the IRA are not subject to income tax. A taxpayer in a 40% income tax bracket immediately has 40% more of their investment dollars at work due to the tax deduction. Further, if a taxpayer is in a 20% investment income tax bracket, the annual investment returns in an IRA will be 20% higher than in a taxable account. A quick calculation example demonstrates that earning a 5% return in an IRA would only be a 2.4% after tax return in a taxable investment account.
This combination of tax deduction for an IRA contribution and the investment growth without current income tax allows the dollars to grow much faster than in a taxable investment account. This is, however, just a tax deferral not a permanent tax savings. Taxation occurs when an IRA owner receives distributions from their account. Even though income tax will ultimately be due, an IRA owner still benefits since tax paid at some future date is better than paying tax today.
There are some important tax planning opportunities that can either eliminate the ultimate payment of tax or stretch out the payment of the tax for many more years.
For those individuals over age 70 ½, annual distributions can be made from their IRA directly to a charity up to $100,000. Since the charity is tax exempt, no tax is due on the distribution. For the IRA owner, the distribution is not taxable but they do not receive a tax deduction for the charitable gift. Still, many taxpayers will be better off. Since the distribution is not included in current income, the taxpayer will benefit from less phase out of itemized deductions and have lower income amounts for the net investment income tax.
Leaving some or all of your IRA to a charity in your will also eliminates the payment of any tax on the deferred income. Many estate tax planners agree that an IRA is the very best asset to satisfy charitable desires in a will. The tax deferral is eliminated and heirs are left with after tax funds that might otherwise have been used for charity. An IRA account is an asset subject to Federal estate tax, so naming a charitable beneficiary has the additional advantage of reducing potential estate taxes.
Every IRA owner should have a named beneficiary and in most cases, it should not be the estate. IRA funds left to an estate are required to be distributed within five years of death creating a requirement to pay tax on the income deferral sooner.
If left to a spouse, the IRA can be rolled to the spouse’s separate IRA and the spouse is then required to take distributions only when they turn 70 ½. The dollars in the IRA continue to grow tax deferred and the payment of tax is stretched over the spouse’s remaining life.
If the IRA names children as beneficiaries, they must start taking distributions in the year following the year of death of the IRA owner. However, these distributions are calculated based on the child’s life expectancy. Again, the IRA continues to grow and the payout is over many more years based on the children’s life. An inherited IRA for a child cannot be rolled into a separate IRA and must be maintained as a distinct inherited IRA.
A major risk of IRAs is that once an IRA is transferred to a beneficiary, that individual then has full control over the account. This may be a concern for individuals with children from different marriages or a concern the IRA beneficiary may be a spendthrift. IRAs inherited by children are also subject to claims of creditors of that child or potentially their spouse. IRA owners with these concerns or otherwise wishing to have more control over the IRA account after death might consider a trusteed IRA. Terms can be established that will help control distributions from an IRA after death to be consistent with the wishes of the IRA owner and also provide more creditor protection.
The tax rules for contributions to an IRA, distributions from an IRA and naming an IRA beneficiary are complex. Failure to comply with these rules can result in significant penalties and/or the unintended payment of tax. Please consult your tax adviser before implanting any of the suggestions contained in this discussion to be sure your individual situation is carefully considered.