At the death of an owner of a large IRA, 401-k or other retirement account, the retirement assets 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 and what it is worth at the time 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. What this means is all retirement accounts (except Roth IRAs) will be subject to federal income tax and state income tax at the death of the IRA owner. These are the first two of the potential of six separate taxes that retirement account may be subject to.

Next, if the IRA owner’s estate is large enough, the retirement asset could also be subject to a federal estate tax and a state estate tax. In 2009, a person’s estate would be subject to federal estate tax if the net estate (all assets owned by the person (including residence, retirement accounts, life insurance, stock, bonds, mutual funds, other real estate and business interests) minus all debt of the decedent) exceeds $3.5 million. The federal estate tax is a flat rate of 45% of the amount over $3.5 million. California does not currently impose a state estate tax, but many other states impose state estate and inheritance taxes on net estates of as low as $1 million at death.

The final two taxes that could be imposed on the same retirement assets are the federal and state generation-skipping tax. The 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 ore other related person more than one generation younger than the retirement plan owner or to an unrelated person more than thirty-seven and one-half years younger than the retirement plan owner. Because of the relatively generous generation skipping-transfer tax exemption amount ($3.5 million in 2009), it is relatively rare to encounter a situation where the GST Tax needs to be paid. However, because of the powerful results that can be achieved through tax deferred compounding (see illustration below), it is often desirable to name a trust for a grandchild or other younger person as the beneficiary of a retirement account.

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 right, a young beneficiary of a $1 million IRA could be left with only $150,000 to $300,000 to spend after all the taxes are paid. But it doesn’t have to be this way. With proper income and estate tax planning, that $1 million dollar IRA could turn into several million in spendable after-tax cash for the beneficiary.

The Power of Tax-Deferred Compounding

Albert 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 6% return, the investor’s money would double in twelve 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 that calculation several steps further, at a ten percent 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 ten percent rate 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 5.63% annually over the fifty years ending on December 31, 2008 and 8.20% annually over the twenty-five years ending the same date, while S&P 500 grew an average of 5.81% annually and 7.17% annually over the same respective time periods.

Planning Example

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 perform 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 amply illustrates 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. If you have a large retirement plan and would like to know more about this type of planning, give our law firm a call at 951-787-7711 and we will schedule you for a free one-hour consultation.