The IRA Hazard Awaiting Your Children
If there’s a thought that drives a lifelong saver crazy, it’s the specter of his or her lifelong savings ending up in the hands of the government!
There’s a reason you’ve foregone the purchase of all the unnecessary toys, that the majority have fallen prey to, in favor of disciplined savings all these years.
You wanted to reach a stage in your life when you were completely financially independent. No need to have to rely on any handouts from anyone.
The freedom to do what you want, when you want, with whomever you want, all without worrying about running out of money.
And, if you didn’t live long enough to spend it all, your family would enjoy the benefits of all your hard work.
Enter The IRA Hazard
Chances are great that a substantial amount of your investments that you’ve arranged to go to your family are held in your IRA (or 401(k) or 403(b) if you’re still working).
Unfortunately, there’s a huge IRA Tax HAZARD awaiting your children when you pass away.
And, if they’re not careful, and are not well informed, almost half of your IRA will immediately be lost to taxes.
Let’s walk through an example…
Charlie and Barbara
Charlie and Barbara been married for 40 years, and have 3 children who are all out of college and in the workforce.
After Charlie retired, he rolled over his 401(k) and pension plan to an IRA where he named his wife Barbara as his primary beneficiary, and his 3 children as secondary (or contingent) beneficiaries in equal shares.
Two years into retirement, Charlie suffers a heart attack and passes away. (Sorry for the blunt shock value of the story, but it’s necessary to make the point)
When Charlie passes away, as Charlie’s spouse and beneficiary, Barbara may transfer the money that was in Charlie’s IRA into her IRA without paying any taxes. (Key point: ONLY spouses can do this.)
Now, let’s fast forward ahead 3 more years. Barbara gets sick, and after a long battle, she passes away.
At this point, Barbara’s children have some decisions to make as the beneficiaries of their deceased mother’s IRA. In far too many cases, here’s what happens:
They call the institution where the IRA was held (bank, investment firm, insurance company, etc.) to inform them that their mother has passed away and to find out what their options are.
Depending on who receives that phone call, here’s the answer that they’re likely to hear:
“We’re very sorry to hear about your loss. We’re going to send you out an IRA distribution request form. Please each sign the form and return it to us along with a certified death certificate and we’ll get the checks out to you within 7 to 10 business days.”
Sounds simple enough, right?
What just happened?
Your ENTIRE IRA Just Became Taxable
The children just paid taxes on the entire balance of the money in the IRA!
Depending on their own personal tax brackets, it’s likely that they gave up 35-40% of their share in federal and state income taxes in one fell swoop!
Let’s suppose that each of the 3 children’s shares in their mother’s IRA was $500,000. That means that as much as $200,000 would instantly go to pay federal and state income taxes! And, that’s just for one of the kids.
That’s a combined total of $600,000 going to taxes for all three kids!
Imagine that. You work your entire life. You diligently save your money. You select sound investments. You do everything right and with one phone call to an uninformed company representative, 35-40% of your hard-earned savings is gone in one shot!
What Should They Have Done?
Each of the kids actually had another option with their share of their mother’s IRA. One option was to just cash it all out. But, as I mentioned, that has enormous tax consequences.
The second option, which is all too often omitted from the discussion, is to “re-title” their portion of the IRA to an Inherited IRA, leaving their deceased mother as the deceased owner of the IRA and them as the beneficiary.
By doing this, they are only required to withdraw and pay taxes on a small amount of the money from the IRA each year, leaving the rest to grow tax deferred for the rest of their lives if they wish!
The amount of money saved in the short term and the long term is staggering.
Now, in order to qualify for this “Inherited IRA” tax deferral plan, there are certain IRS requirements that they have to fulfill in order to make it work.
In a future blog entry, I’m going to outline the steps required by the IRS that your children and grandchildren have to follow perfectly in order to qualify.