Estate Planning for Persons with Large Retirement Accounts

Many of the law firm’s estate planning clients in Riverside County and San Bernardino County have large retirement accounts, such as Individual Retirement Accounts (IRAs), 401-K’s, and Tax Sheltered Annuities, also known as 403(b) and 451 accounts.

Retirement Accounts are Subject to Income Tax at Death

Estate Planning for Persons with Large Retirement Accounts

At the death of an owner of a large retirement account, like an IRA, the retirement asset can be subject to as many as six separate taxes. Most assets get what is known as a step-up in basis at death. What this means is that the beneficiary inherits the asset at its value at date of death and the asset can generally be sold with little or no income tax consequences. Retirement accounts are among a special class of assets known as income in respect of a decedent, or IRD. This means all retirement accounts (except for Roth IRAs) will be subject to federal income tax and state income tax at the death of the account owner. These are the first two of the six potential taxes that retirement accounts may be subject to.

Retirement Accounts May Be Subject to Estate Tax at Death

Next, if the owner’s estate is large enough, the retirement asset could also be subject to a federal estate tax and a state estate tax. In 2012, a person’s estate would be subject to a federal estate tax if the net estate (all assets owned by the person (including residence, retirement accounts, life insurance, stock, bonds, mutual funds, and other real estate and business interests) minus all debt of the decedent) exceeds $5,120,000. In 2013, that amount is scheduled to drop to $1 million. The federal estate tax currently 35%, but it could go as high as 55% beginning in 2013. California does not currently impose a state estate tax, but many other states do impose state estate and inheritance taxes.

Retirement Accounts May Be Subject to GST Tax at Death

The final two taxes that could be imposed on that IRA owned by our decedent are federal and state generation-skipping transfer (GST) taxes. This tax would only be imposed if the retirement plan owner had a sufficiently large net estate and the retirement plan owner left his or her retirement assets payable to a grandchild/other related person more than one generation younger than him or her or to an unrelated person more than thirty-seven and a half years younger.

Many of our estate planning clients desire to leave their IRAs, 401-K’s and other retirement assets to grandchildren because they want to delay the income taxation of the retirement account for as long as possible. However, if the retirement plan is subject to generation-skipping transfer taxes, this would be a major mistake, as this would subject the retirement account to an additional 35% tax on top of the income taxes and estate taxes that were already paid. Because the current GST Tax exemption amount is relatively generous at $5,120,000, it is relatively rare to encounter a situation where the GST Tax needs to be paid on retirement accounts. However, this will become more of a problem if the GST Tax exemption amount is lowered in 2013.

Retirement Accounts are Most Heavily Taxed Assets

With all the taxes a retirement asset can be subject to at the death of the owner, it is not unusual to see the after-tax proceeds payable to the beneficiary at death suffer a shrinkage of as much as 70% – 85%. That’s correct: a young beneficiary of a large IRA could be left with only 15% to 30% of the retirement account to spend after all of the tax is paid. But it doesn’t have to be this way. With proper income and estate tax planning, a $1 million IRA could turn into several million in spendable after-tax cash for the beneficiary.

The Power of Tax-Deferred Compounding

Tax-Deferred CompoundingAlbert Einstein is quoted as saying “the most powerful force in the universe is compound interest.”

Many people are unfamiliar with the power of compounding and have never heard of the Rule of 72. The Rule of 72 provides you with the answer as to how long it would take an investor at any given interest rate to double his or her money. So, at a 3% interest rate, the investor’s money would double every twenty-four years. At a 7% return, the money would double in ten years. And at a 10% return, the initial investment would double in seven years.

Carrying the analysis several steps further, at a 10% return, a $1 million IRA would be worth about $4 million in fourteen years, $8 million in twenty-one years, and $16 million in twenty-eight years. In today’s economy, a 10% Return seems unheard of, but historically investments such as stocks and real estate have averaged 6% to 10% annually over long investment horizons. For instance, the Dow Jones Industrial Average grew an average of 7.28% for the year-to-date ending November 30, 2012; 2.59% annually for the five years prior to November 30, 2012 and 6.89% annually for the ten years ending November 30, 2012.

An Example of Estate Planning for a Large IRA

Let’s use the example of John and Sally Smith. John is age 70 and he has an IRA of $500,000. Sally is five years younger than John. He and Sally have a comfortable lifestyle, a sizable estate, and they would like to continue to defer taxation of the IRA for as long as possible and eventually distribute it to their granddaughter, Stephanie. Let’s assume for this illustration that John and Sally can invest the IRA for long term growth and that it will grow at an average return of 6% annually for the duration of the time periods illustrated.

Assuming John lives to age 85, he would be required to take minimum distributions from his IRA according as provided under the IRS Uniform Table. During that period of time, John would withdraw a total of $424,171 and his IRA would be worth $577,342 at the time of his death (again assuming a 6% growth rate).

At his death, Sally could engage in a “spousal rollover” of John’s IRA into an IRA for herself. Assuming Sally lived another ten years and she took only the distributions required by the IRS under the Uniform Table, she would receive distributions totaling $383,869 and the IRA would be worth $538,541 at the time of her death.

Stephanie is age 30 at the time of Sally’s death. John and Sally leave the IRA to a special trust for Stephanie’s benefit. The trust is designed to allow the IRA to continue to grow tax-deferred for the longest period possible and to provide for Stephanie’s long-term needs. The distributions from the trust are based on the IRS Single Life Table, which estimates Stephanie will live another fifty-four years. Over that period of time, Stephanie would receive a total of $3,993,978.

This illustration shows the powerful force of compounding that Albert Einstein spoke of. With proper income and estate tax planning, a $500,000 IRA made distributions totaling $5,109,861 to three beneficiaries over a period of seventy-nine years.

Riverside Estate Planning Law Firm Offers Free Consultation
If you have a large retirement plan and would like to know more about this type of planning, contact us or call 951-787-7711, and we will schedule you for a free hour long consultation.



Dennis M. Sandoval, A Professional Law Corporation, of Riverside, California, provides representation throughout Riverside, Corona, Norco, Moreno Valley, Eastvale, Jurupa Valley, Mira Loma, Redlands, Ontario, Rancho Cucamonga, Upland, Chino, Chino Hills, San Bernardino, Fontana, Rialto, Colton, Perris, Hemet, Sun City, Temecula, Murrieta, Menifee, Winchester, San Jacinto, Lake Elsinore, Idyllwild, Lake Arrowhead, Crestline, Running Springs, Wrightwood, Yucaipa, Palm Springs and Palm Desert.

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