How to limit Uncle Sam's share of retirement benefits

Here's a review of the things you can do to extend tax breaks on pension and IRA accounts for your lifetime and your heirs'.

By Lawrence Farber
Contributing Writer

When a Chicago internist told his accountant he'd inherited a $100,000 IRA, he got a pleasant surprise. Dr. Brown (as we'll call him) knew he'd be liable for income tax when he withdrew the money, just as the original owner would have been if he'd lived. Because Brown's 2002 tax bracket is 35 percent, he figured that closing the IRA this year would cost him $35,000. But the accountant explained that a little-publicized rule will allow Brown to deduct the $41,000 estate tax on his $100,000 legacy, even though the estate had paid the bill. The doctor would owe income tax on only $59,000, saving him more than $14,000.

Brown's accountant also pointed out that the doctor could take minimum distributions over his expected life span, instead of cashing in the IRA immediately. This would let him enjoy tax-deferred earnings on the IRA balance, and he could still deduct a prorated share of the estate tax each year.

You may not expect to inherit any IRAs or other retirement plan accounts (which generally are covered by the same tax law provisions), but chances are they'll comprise a sizable part of your estate. While you're still around, you can do a good deal to minimize future taxes for your heirs. Here's how.

Give your spouse a free hand. You've probably named your spouse as beneficiary of your retirement plan. In fact, the pension law won't let you do otherwise without his or her written consent. But your plan can specify how the funds will be distributed when you die.

A lump-sum payout offers the greatest flexibility. Your spouse can then roll the money into a new or existing IRA of his or her own and, if desired, delay withdrawals until after age 70 1/2. The 2001 tax law revision even allows a rollover to a pension plan in which your spouse participates.

Thanks to the marital deduction, the inherited funds aren't subject to estate tax. Although that's good in itself, it means your spouse won't be able to reduce the income tax on plan withdrawals by claiming a deduction for estate tax paid. So your spouse may want to withdraw as little as possible. Whoever later inherits the remaining balance of the plan account will be taxed on the income but can claim a deduction for part of any tax paid on your spouse's estate.

Stretch the distribution period. Recently adopted IRS regulations make it possible to extend the tax-deferred growth of pension and IRA funds. As the account owner, you must still begin taking annual distributions by April 1 of the year after you reach 70 1/2. However, the mandatory withdrawal percentages, which get progressively larger with age, have been lowered, lengthening the life of an account. Moreover, your beneficiary's age no longer affects your withdrawals, with one exception (see "Figuring required distributions"). You may want to modify your estate plan to reflect these changes.

Dr. Martin, for example, expects to have around $500,000 in his IRA when he has to begin taking mandatory distributions. Because he and his wife are the same age, the former rules would have required an initial withdrawal of roughly $25,000, if she were the beneficiary. Substituting their daughter Eleanor would have cut that to less than $20,000.

The new regulations, however, let the doctor use the lower figure even with Mrs. Martin as beneficiary. That way, she'll inherit the IRA, and when she dies, the IRA can pass on to her daughter. Eleanor can then use her own life expectancy to compute minimum annual withdrawals, provided she begins them by Dec. 31 of the year following her mother's death. If Eleanor dies while the IRA still exists, her beneficiary (assuming she has named one) can continue the minimum withdrawals, but they must be based on Eleanor's original life expectancy, even if her beneficiary's is longer.

Bear in mind that an IRA beneficiary can take more than the required minimum distribution. In the previous example, suppose Eleanor inherits the $500,000 IRA when she's a 25-year-old graduate student with little other income. She'd be required to take an initial IRA distribution of around $8,800, but she could withdraw several times as much and still not pay more than 15 percent tax on the income. This may be a better move than boosting withdrawals in later years when she's likely to be in a higher tax bracket, especially if no estate tax deduction is available to her.

Handle Roth IRAs with care. Dr. Preston told his wife that he wants to remember their nephew with a $20,000 bequest. She suggested substituting the young man's name for hers as beneficiary of a Roth IRA currently worth about that much. If the nephew leaves the legacy intact, Mrs. Preston pointed out, it could easily double or triple in 10 years or so, and all the money would be free of income tax.

Unfortunately, the tax rules could make the Prestons' gift less handsome than it seems. Although Dr. Preston, as the original owner of the Roth account, could keep it intact for as long as it suits him, as a nonspouse beneficiary his nephew must close an inherited Roth by the end of the fifth year after Preston's death. Or else he must take annual minimum distributions based on his life expectancy, just as with an inherited traditional IRA, except that they're tax-free. The penalty for failure to comply is 50 percent of the distribution shortfall.

In contrast, if Mrs. Preston remains the beneficiary, the rules allow her to replace the doctor as owner when she inherits. That means she can invade the account at will (if she's at least 59 1/2) or let it grow indefinitely, without incurring regular tax or a penalty. Accordingly, Preston would be wise to preserve these advantages and make other provisions for his nephew.

Keep more by giving some away. Dr. Richard wants to make a gift to her favorite charity when she dies. Instead of a cash donation, she may do better for her other heirs by naming the charity as beneficiary of her IRA. Unlike individuals, exempt organizations don't pay income tax on inherited retirement accounts. So the IRA's full face value would go to the charity, and Dr. Richard could leave the other heirs an equivalent amount, free of income tax.

The new distribution rules remove one drawback to this tactic. Formerly, the minimum yearly withdrawals an IRA owner had to take would increase if she (or he) failed to name an individual as beneficiary, because then they'd have to be based on her life expectancy alone, rather than on the joint life expectancy of two persons. But as mentioned earlier, the minimums no longer depend on who the beneficiary is.

What if Dr. Richard's IRA is larger than the amount she wants to donate? She can, of course, name both the charity and an individual as beneficiaries and stipulate the fraction going to each. In that case, though, the individual heir might have to take his share within five years, instead of spreading withdrawals over his lifetime. To get around this, the doctor should set up separate subaccounts under the IRA, or better yet, transfer an appropriate portion into a second IRA.

Sometimes a more tax-efficient alternative is to leave the IRA to a charitable remainder trust, rather than directly to the charity. The trust can provide income for life to your spouse, children, or other individual beneficiaries you specify, but the payments don't have to comply with the IRA distribution rules. What remains will go to the charity with no reduction for income tax, and your heirs will benefit from an immediate estate tax deduction, based on the value of the remainder as calculated from IRS tables. Income received by the beneficiaries will be taxable to them, but overall tax savings may be substantial, particularly if large bequests are involved.

Make sure your heirs have ready cash. Aside from his pension plan, Dr. Sloan's assets consist almost entirely of real estate, much of it undeveloped land. He's well able to support his wife and children from his practice income and is satisfied with the growth of his investments. Although he'll leave his family a sizable estate if he dies prematurely (he's 60 now), he'll also leave them a tax problem.

With the doctor gone and little current income available from his real estate holdings, Mrs. Sloan will have to depend on the pension fund to meet family expenses. Everything she takes out will be subject to income tax, and there'll be no offsetting estate tax deduction. She can, of course, raise money by selling some property, but this could mean accepting discounted bids if the real estate market happens to be weak.

While he's still around, Dr. Sloan can make things easier for his widow by gradually shifting some of his assets into income investments. If he prefers to stay with real estate, he might consider replacing land with rental property in a tax-free exchange. That way he'd postpone capital gains tax, while providing Mrs. Sloan with a future source of income. She'd be taxed on this income, but her inherited retirement plan assets would continue to grow tax-deferred.

Life insurance is another shield against heavy tax blows. The proceeds aren't subject to income tax and can also be protected against estate tax if need be. The simplest way to dodge estate tax is for Sloan to transfer ownership of the policy to his wife. But if this could result in estate tax at her death, an irrevocable life insurance trust may be better. In that case, contributions Sloan makes to the trust to pay the premiums may be taxable gifts, but the $1 million lifetime gift tax exclusion will apply.

Leave final choices to posterity. It's more important than ever for your estate plan to accommodate changes after your death—not only alterations in your heirs' needs, but in the tax laws as well.

Dr. Gray wants to split an IRA fund between his two unwed sisters. One has prospects for marriage to a well-to-do boyfriend. If that happens, she could end up with highly taxed income she doesn't need and would be glad to let the other sister inherit. Rather than try to guess how things will turn out, Gray can simply name them as joint beneficiaries of his IRA. Either could become the sole beneficiary if the other sibling waives her rights by the end of the year after Gray's death.

Dr. Stone's problem is different, but its solution is somewhat similar. His will divides his assets between his wife and a bypass (credit-shelter) trust for the children. Among other assets, his wife will inherit his pension plan, currently valued at more than $3 million. No estate tax will be due when he dies, but if too little goes into the children's trust, Mrs. Stone's estate may exceed the tax credit available at her death. Because the credit is scheduled to increase periodically, the doctor can't foresee what division will achieve the best tax result.

However, Dr. Stone can sidestep the question by naming the trust a contingent beneficiary of the pension plan. When he dies, Mrs. Stone, as primary beneficiary, can retain whatever portion of the benefits she chooses. The rest will go to the credit-shelter trust. If the terms of the trust are appropriately drawn, each child's plan share can be paid out over his or her life expectancy. This arrangement will minimize both estate and income taxes.

In a nutshell, death may be certain, but taxes aren't. With expert guidance, you can pass along to your heirs the lifetime tax benefits from your retirement accounts. You may need continuing help from consultants to modify your estate plan as the law changes, but their fees will be money well spent.

Figuring required distributions

To calculate the annual required minimum distribution (RMD) from an account you own, divide its previous year-end balance by your present life expectancy as shown in the IRS "Distribution Period Table" (Table III in Appendix C of Publication 590).*

For example, if you own an IRA that was worth $100,000 at the end of 2001 and your 70th birthday occurred in the first half of 2002, your initial RMD will be $3,817—that is, $100,000 divided by 26.2, the figure listed in the table for age 70. To calculate your RMD for 2007, say, you'll divide the 2006 year-end account balance by 21.8, the divisor for age 75. That means you'll have to withdraw 4.6 percent of the account total, compared with only 3.8 percent at age 70.

A spouse beneficiary also can follow the previous procedure, but a nonspouse beneficiary must use a different method to figure life expectancy. Let's say you die in 2003 and your IRA goes to your son in 2004, when he's 40. He must look in Table I of IRS Publication 590 to find his single-life expectancy in 2004, which is 42.5, and use that as the divisor. Each year thereafter, he must reduce this number by 1, so that the divisor is 41.5 in 2005, 40.5 in 2006, and so on. When the divisor shrinks to less than 1, his calculated RMD will be greater than the actual account balance, so he'll have to withdraw all that's left. This will happen in 2046.

*If your spouse is the beneficiary and is more than 10 years younger, you can lower your RMD by using your joint life expectancies (see Table II of Appendix C in Publication 590).

 

Lawrence Farber. How to limit Uncle Sam's share of retirement benefits. Medical Economics 2002;15:50.