Despite their name and intended purpose, individual retirement accounts don't always get used for retirement.
Some IRA owners intend to pass the money on to their children, and others will unfortunately die before they can tap the funds. One thing is for sure: How you plan today can affect the size of Uncle Sam's take after your death. Make the wrong move, such as failing to name a beneficiary, and the tax collector could snatch up to 90% of the IRA's value.
When trying to minimize the government's portion of an inherited IRA, the beneficiaries are the first consideration. Who the beneficiary is determines what happens to the account. Naming a spouse as beneficiary is the most tax-advantageous because bequests to spouses are exempt from estate taxes, though they must still pay income taxes on withdrawals. What's more, spouses can roll over the account into a new IRA, choose new beneficiaries, and begin the required minimum payouts based on their age, not the original IRA owner's. That can protect the tax-deferred growth for years.
A 55-year-old spouse who inherits an IRA, for example, wouldn't have to start distributions until 70 1/2. At that age, minimum withdrawals, which are based upon a formula that considers life expectancy and the amount in the plan, must be taken annually. But before withdrawals can be made, the spouse must put the IRA in his or her own name and choose a new beneficiary. If the spouse needs IRA funds before the penalty-free withdrawal period of age 59 1/2, he or she can leave money in the original account. As long as the surviving spouse begins payouts before the original owner would have turned 70 1/2, no 10% early-withdrawal penalties are due.
When someone other than a spouse is inheriting an IRA, the situation gets stickier. He or she can't roll over the money into a new account, and estate taxes must be paid immediately. But if the IRA owner dies before 70 1/2, the beneficiaries can spread distributions over their own life expectancy as long as they start withdrawals by the end of the year after the owner's death and keep the account in the owner's name, says Seymour Goldberg, an IRA expert and attorney with Goldberg & Ingber in Garden City, N.Y.
If the IRA owner dies after 70 1/2, after the first payout has been made, then the beneficiaries must take distributions at least as quickly as the schedule used prior to the owner's death. Otherwise there is a 50% penalty on the portion that should have been withdrawn.
Of course, all beneficiaries other than spouses will pay estate taxes on an inherited IRA. But a recent change in the IRA withdrawal policy can help minimize the bite. Typically, any IRA distribution above $155,000 is subject to a 15% excise penalty on top of ordinary income tax. But Congress has granted a moratorium from 1997 to 1999 that allows unlimited withdrawals excise-tax free. "Owners close to 70 or older with accounts over $2.5 million," should take advantage of the opportunity, advises Steven Lockwood, president of Lockwood Pension Services Inc. in New York. They can accelerate withdrawals and use the money to buy a second-to-die life-insurance policy. The policy is owned by an irrevocable trust, with the kids as beneficiaries, thus exempting the death proceeds from estate taxes.
LONGER PAYOUTS. The government gets the most money when no beneficiary is named. The account reverts to the estate, and all the money must be withdrawn within five years after the owner's death. Estate and income taxes could eat up most of the IRA's value.
IRA owners eager to keep cash out of Uncle Sam's hands must also decide how long the payouts will continue and how much they will be. Determining whether distributions will be based on a joint or single life expectancy answers these questions. "Joint life with a spouse or another beneficiary guarantees that the payouts and tax shelter survive longer than a single life expectancy because the minimum payouts will be lower," says Bob Phillips, an accountant with Whipple & Co. in Indianapolis. Set it at the minimum, because more can always be withdrawn.
Whether a retiree should break into an IRA or use other savings depends on the individual. If you plan to pass along money to your heirs, for example, tap other savings first to maintain the tax-deferred growth in the IRA.
No doubt, it's tough to decipher the IRA inheritance rules. But it's even tougher to lose a big part of your tax-sheltered savings to the IRS because you failed to plan properly.