Roth IRA accounts have been available since 1997. Unlike a Traditional IRA, Roth IRA contributions are taxed in the year of the contribution but never taxed again if certain requirements are met.
If you are a single filer with gross income of up to $52,525 or joint filers with gross income of up to $105,050 for the 2020 tax year, all of your income is taxed at 12% or less, and we strongly encourage you to make Roth IRA contributions rather than Traditional IRA contributions.
The magic of compounding means, the earlier you start, the greater the tax-free growth within the account. If you are 20 when you start making contributions, you could be looking at four doubles of your original contribution by the time you retire at age 60. That means a $6,000 contribution this year could grow to $96,000, creating $90,000 of tax-free income for your retirement years.
With today’s historically low income-tax rates, it would be prudent to put as much money as one can into a Roth IRA. Always consult your CPA before making this decision, but one could argue the tax-free growth and withdrawals outweigh the hurt of paying today’s top tax rates.
Contribution and Income Limits
For 2021 eligible individuals can contribute up to $6,000 if they are under age 50 and $7,000 over the age of 50. You can contribute 100% of any eligible income up to these limits.
For single filers with Adjusted Gross Income of less than $125,000 ($124,000 for 2020) can make a full Roth IRA contribution. If the adjusted gross income is between $125,000 and $140,000 ($124,000 to $139,000 for 2020) they can make a partial Roth IRA contribution. For joint filers the threshold is below $198,000 AGI ($196,000 for 2020)and the phaseout is between AGI of $198,000 to $208,000 for 2021 ($196,000 to $206,000 for 2020). For adjusted gross incomes above these amounts, a back-door Roth IRA strategy will be needed.
Back-Door Roth IRA Contributions
Without income limitations for converting assets in a Traditional IRA to a Roth IRA, many who are disqualified for income resort to the back-door method for funding a Roth IRA. This works because anyone may open and contribute to a non-deductible Traditional IRA, even if you are covered by a qualified retirement plan.
Once the funds are deposited into the non-deductible Traditional IRA, they can then be converted to a Roth IRA. This has the same net income-tax effect as contributing directly to a Roth IRA. The IRS recently loosened the back-door conversion rules and allow for immediate conversions, where in the past investors were recommended to wait a few months before converting to satisfy the IRS.
The 5 Year Rule
Another reason to open a Roth IRA is the flexibility it can provide to fund emergencies that may arise over your life.
You can always withdraw any Roth IRA contributions you have made without taxes, after all, you paid income tax on the money prior to making the contribution. However, if you haven’t had the Roth IRA open for at least five years, your distribution could still be subject to a 10% tax penalty, similar to the early withdrawal penalty for Traditional IRAs.
The five years for withdrawals begins on January the 1st of the year you open the account, not when you make subsequent contributions. There is also a five-year rule for Roth IRA conversions that start in January of the year you make a conversion; this prevents someone from using a Roth IRA conversion to avoid early distribution penalties from early Traditional IRA withdrawals.
The Younger, The Better
Tax-free growth and tax-free distributions are very enticing, especially for young investors. The more time your account grows tax-free, the better. Another point to make is that the more of your nest egg you have in a Roth IRA, the less your Required Minimum Distributions (RMDs) will be during retirement. Which inherently leads to you and your financial advisor having more ability to control/minimize income taxes during retirement years.
If you're age 72 or older you probably know you must begin taking distributions from your IRA -whether you want to or not. The IRS life expectancy tables determine your required minimum distribution (RMD) based on the previous years ending balance for your IRA and your attained age for the tax year.
The qualified charitable distribution rules provide those subject to RMDs an option that can help them reduce their income tax liability by having certain charitable contributions made directly to a qualified charity. Given the changes to itemized deductions and the standard deduction in the 2017 tax law update, the qualified charitable distribution rules for your IRA account becomes even more important.
If you make charitable contributions throughout the year, it would be wise to consider making those contributions directly from your IRA. Up to $100,000 of charitable distributions from each IRA owner's accounts can be excluded from your taxable income each year.
Say you plan to give $10,000 to your church or another qualified charity and you are receiving taxable distributions from your IRA. If you make the contribution to the charity directly from your IRA, your $10,000 gift will not be reported as income on your income tax return.
If you instead receive these funds as income from your IRA distribution and then send the same $10,000 to the charity it is included in your taxable income and could result in higher Medicare premiums and a higher percentage of your social security income being taxable. If you do not have itemized deductions that exceed the new $24,000 per couple or $12,000 per individual standard deduction, you could lose all the tax benefits of your generosity.
By having the distributions sent directly to the qualified charity from your IRA, you will exclude the amount from your taxable income, potentially lowering your Medicare premiums, the taxable portion of your social security benefits, and your overall income tax rate at both the federal and state level.
If you follow this strategy, be sure to let your income tax preparer know. There may be no indicator on the 1099R you receive at the end of the year that shows that part of your distribution is non-taxable, so there is a chance many people using this strategy are over-paying their income taxes each year.
Why you might not want to rollover that old 401k
*The rollover strategies discussed also apply to 403b, 457b, 401a and other employer sponsored qualified retirement plans
For many high wage earners, making contributions up to annual Roth IRA limits (6k/$7k over 50; 2020) via the backdoor Roth IRA strategy is an appealing way to generate income tax free growth and income for future years. The backdoor Roth strategy entails making a non-deductible IRA contribution and immediately converting that contribution to a Roth IRA account. If you have no other rollover tax deferred IRA accounts when you execute this strategy, then you have simply moved money from a taxable account into a tax-free account.
What If I have existing Rollover IRA and/or Traditional IRA Assets?
When executing the backdoor Roth strategy, if you have any tax-deferred Rollover or Traditional IRA Assets, i.e. you haven’t paid income taxes on them yet, the Roth conversion will result in at least some of those funds being taxed in the year of the conversion.
For example, let’s say you have a Traditional IRA or Rollover IRA worth $60,000 and make a non-deductible contribution of $6,000 to this IRA in accordance with your backdoor Roth IRA strategy. When you convert the same $6,000 from your Traditional or Rollover IRA to Roth IRA assets, you’ll actually be taxed on ~91% of the conversion, which creates extra taxable income of $5,460 for the tax year.
This overlooked tax trap results from IRS rules which mandate, for tax calculations, your tax-deferred contributions and gains and non-deductible contributions from all IRA accounts (Rollover, Traditional & Roth) are combined into a theoretical IRA pot. From this theoretical pot, the IRS requires you to calculate the ratio of tax-deferred dollars to non-deductible dollars; the percentage of tax-deferred dollars in your theoretical account is the percentage of your Roth IRA conversion that will be taxed.
In this example your non-deductible $6,000 contribution to your Traditional IRA or Rollover IRA is divided by the total account value of $66,000—just roughly 9% is not subject to income taxes at the time of conversion.
The aggregation rules are one of the few reasons you should carefully think about not rolling over an old 401k or other employer plan. If the funds remain in a 401k, 401a, 403b, 457b etc. they are not subject to the aggregation rules.
While there’s no avoiding taxation of previously deducted personal Traditional IRA contribution assets during a backdoor Roth IRA strategy execution or other Roth conversion, there are sometimes opportunities to clean up existing Rollover IRA accounts to avoid this unpleasant tax consequence.
The Difference Between a Rollover IRA and a Traditional IRA
Though they’re nearly identical, there is a subtle, but significant, difference. You can roll over a 401k to a Traditional IRA or Rollover IRA. If you choose to roll funds into a Rollover IRA, rather than a Traditional IRA, you maintain the ability to roll those funds into another current or future 401k plan, if the plan documents allow.
Why Does That Matter?
There are 401k plans that allow IRA roll-in contributions, but they must come from a Rollover IRA, not a Traditional IRA. If your company has such a plan, you can roll your existing Rollover IRA account into your 401k plan which eliminates the tax-deferred IRA portion of your aggregate portfolio, allowing a high earner to execute the backdoor strategy completely tax-free. Without this keen planning taxes would be paid at high income brackets on the conversion, which is counterproductive to high earner’s overall tax strategy.
Don’t Commingle Rollover IRA and Traditional IRA Assets
If you commingle “regular” Traditional IRA funds and Rollover IRA funds you lose the ability to roll-in former Rollover IRA assets. It’s important to keep the Rollover IRA and Traditional IRA accounts separate. Consider opening a stand-alone Traditional IRA for annual personal IRA contributions and a separate Rollover IRA for rollover assets.
As always, things are rarely as simple as they seem. You should work with a competent Financial Planner to determine the best advice on your personal tax planning strategy.
Questions about tax minimization strategies regarding your 401k rollover or rollover IRA? Click here to setup a no cost discussion with us today!
How High Earners Can Diversify the Taxability of Their Retirement Assets
Our fee only financial advisors often recommend executing a backdoor Roth IRA contribution strategy for high earning clients who max out their tax-deferred and/or after-tax employer sponsored plans and are seeking additional tax favorable approaches to save and grow assets.
These clients often accumulate large levels of tax-deferred dollars in their 401k, 403b, or other employer sponsored plan(s). These tax-deferred contributions help save tax dollars in high brackets now and withdrawals in retirement can be structured for tax savings in the future as well.
On the other end, if we can add in Roth IRA assets to our clients’ portfolios which can be withdrawn in retirement tax-free, we add another tool in the tax-planning belt.
What are Backdoor Roth IRA Contributions
For most wage earners, if you contribute to a Traditional IRA you receive a dollar-for-dollar tax deduction. Here’s an overly simplified look at the tax reduction provided by the combined maximum family deductible Traditional IRA contributions of $12,000 for a married couple in 2020:
Unfortunately, if you earn over a certain level of income and/or have access to an employer sponsored retirement plan (401k, 403b, 457b, etc., whether you use it or not) you lose the deductibility of your Traditional IRA contributions.
**IMPORTANT: Even if you can’t deduct IRA contributions, you can still make them.**
New clients are often surprised when we tell them they’ve been missing out on these tax favorable IRA contributions. Many investors assume they can’t make IRA contributions because they make too much money or already participate and max out an employer 401k or 403b plan. In each case, you can make IRA contributions, you just can’t deduct them.
Unlike Traditional IRAs, when you make contributions to a Roth IRA you pay the taxes now-- or have already paid taxes on the contributions via payroll and will simply not receive a tax deduction for the contribution. The magic of a Roth IRA is that once the assets are in the account and the account has been open for 5 years—all withdrawals of principal AND earnings are tax-free. And tax-free > tax-deferred.
But high earners are not allowed to make direct Roth IRA contributions, because Roth IRAs have their own income level eligibility qualifications:
So-- if you’re single making more than $139,000 AGI or married and earn over $206,000 AGI you can’t make direct Roth IRA contributions AND you don’t get Traditional IRA contributions deducted.
However, if you have little or no Traditional IRA assets to start with, we recommend executing a backdoor Roth contribution strategy. High earners can make non tax-deductible contributions to their Traditional IRAs, receiving no tax deduction for the contributions. Then they can immediately convert that contribution to their tax-free Roth IRA.
Why would you want your investments growing tax-deferred when they could be growing tax-free? Not simple to do, but a no brainer…slam dunk.
How are Backdoor Roth IRA Contributions Taxed?
A key factor that must not be overlooked is the amount of previously tax-deferred Traditional IRA assets a high earner has while executing this strategy. It’s important because Roth conversions are taxed at the ratio of tax-deferred assets to after-tax, or non tax-deferred assets.
For example, let’s say you’re a married high earner and want to start this backdoor Roth IRA strategy. You make the max Traditional IRA contributions of $12,000 ($6,000 each) for you and your spouse for 2020 and plan to immediately convert that to your Roth IRA to facilitate the lifetime tax-free growth mentioned above.
At the same time, you already had $12,000 (again $6,000 each) of tax-deferred contributions from previous years where you qualified for the deduction. Or you could have rolled over tax-deferred assets from an old 401k into your Traditional IRA. Either way, half the assets in the Traditional IRAs were tax-deferred in prior years, and half are non-deductible from 2020’s contribution.
If you convert the $12,000 of non-deferred contributions you made in 2020, it wouldn’t be a tax-free conversion— it would be taxed according to the Roth IRA pro-rata rule. This states you have to use the tax-deferred to non-tax-deferred ratio for taxing of the conversion assets. In this case the ratio is 50:50 ($12k tax-deferred to $12k tax-free), so half, or $6,000 of the $12,000 Roth IRA conversion would be taxed at your normal income tax rates for 2020.
This is important-- because if you’re a high earner, you may want to avoid paying 32%+ Federal taxes this year on that $6,000 taxable portion of the Roth IRA conversion. It may be better to wait until retirement when you’ll likely be in a lower tax bracket, especially if you do some of the tax planning we mention in this article.
The Roth IRA pro-rata rule should give pause to rolling over tax-deferred dollars from 401ks or 403bs into a Traditional/Rollover IRA when a backdoor Roth IRA strategy is recommended. The more assets added to your personal Traditional/Rollover IRA, the higher the taxable percentage of Roth IRA conversions. For these reasons, our financial advisors may recommend clients keep tax-deferred dollars in an old employer plan-- even if those plans have slightly elevated fees or lack diversified, cost-efficient investment offerings. We believe the tax-free savings of Roth IRA assets for a young high earner provide unmatched advantages in terms of investment returns and future tax planning strategies. Getting assets in a high earner’s Roth IRA early while avoiding unnecessary taxes at their currently high tax brackets provides great value to our clients.
On the other hand, some clients prefer to fill up their brackets with Roth conversions to eventually get rid of all Traditional IRA tax-deferred assets, never having to worry about Roth conversion taxes again. Regardless—your taxable income level and tax bracket management must be thoroughly analyzed to make the right decision.
Why Should I Build Roth IRA Assets?
Saving on Pre-Medicare Health Insurance Premiums
For example, let’s say a couple retires at age 60, with 5 years before Medicare eligibility. Our fee only advisors use taxable investment accounts and tax-free Roth IRA assets to strategically qualify millionaires for Premium Tax Credits under the Affordable Care Act that can offset some of the cost of healthcare insurance. Monthly private marketplace insurance premiums at age 60 are likely to be $1,000 per person—meaning if you and your spouse plan to retire at age 60, every year until age 65 you’ll fork over $24,000 alone on healthcare insurance premiums before you step foot in a doctor’s office. That can put a damper on early retirement plans.
Our fiduciary advisors can situationally use taxable and Roth IRA assets to qualify even our most wealthy clients for Premium Tax Credits, which cover a portion or all of a family’s health insurance expenses. In the above example, that’s a potential savings of up to $120,000 in premiums from retirement at age 60 to Medicare eligibility at age 65—and a glaring reason everyone should invest in a financial plan.
Recently, we’ve heard several current and prospective clients mention they’re going to beat high healthcare insurance costs during pre-Medicare retirement years with some sort of too-good-to-be-true Medi-Share plan. Please reconsider. These plans are not actually health insurance and leave your family’s wealth and health in jeopardy. One un-insured serious hospitalization could put your entire financial future needlessly at risk.
Long Term Capital Gains Rates Saving
We also use taxable and tax-free assets to manage tax brackets via favorable capital gains rates, and in some cases, help our clients pay 0% on capital gains through complex tax planning strategies. For those high earners today, as tax laws are, as is, we’d be able to structure their taxable income so they can optimize favorable capital gains rates while ensuring their assets at 12% Federally. That’s a Federal tax savings of $22,000+ for every $100,000 in their IRA. Not a bad deal for someone being taxed at 24% or 34%+ today and may even pay the 3.8% Medicare investment income surcharge.
Other Uses for Roth IRA Assets
Tax-free income can help manage tax brackets/income in retirement and can lead to enormous tax savings if planned correctly. If you max out your employer retirement plans and are looking for even more tax diversification of your assets, a backdoor Roth IRA strategy is a good choice. There are many factors to analyze to ensure you realize the tax savings these strategies provide.
If you could use help determining the most appropriate course of action to take with your excess savings give us a call and get started with a financial plan today.
This is being written as the bill is still in progress. Edits may be required as more information becomes available. Please check back for updates and be sure to consult a financial professional before implementing any of the strategies suggested in this post.
The Senate has passed an emergency relief bill that is expected to pass the House later this week. The package is over $2 trillion in scope, $6 trillion if you include loan provisions, and is the largest relief bill in the history of the United States.
Relief Payments Made Directly to Taxpayers
Let’s start with the direct payment checks you have probably heard about. In general, individuals will receive payments of $1,200 and joint filers $2,400, plus $500 for each qualifying child. The definition of a qualifying child is already in the current Child Tax Credit Guidelines i.e. if you claim someone as a dependent child on your tax return in 2020 then they’ll qualify for the additional $500 per child payment.
High income taxpayers will see these amount reduced as income exceeds $150,000 for joint filers, $112,500 for head of household, and $75,000 for single filers. For every $100 over those limits the payment is reduced by $5 until you reach zero. That means joint filers earning $198,000 or more, heads of households earning $136,500 or more and single filers earning $99,000 or more will receive nothing.
The payments will be based on the most recent tax return filed. So, if you have already filed for 2019 you are stuck with those earnings. If you have not filed for 2019, then your payment will be based on 2018 return information. If your income is higher in 2019 than 2018 DO NOT FILE YOUR TAXES UNTIL LATER. On the other hand, if your 2019 income is lower than 2018 IT IS IMPORTANT TO FILE YOUR TAXES NOW.
The payments will be direct deposited for taxpayers who elected to have direct deposit on their income tax forms. This could be a problem if the direct deposit instructions you provided in 2018 are to an account that has since been closed, or if you have divorced or separated since your 2018 tax filing. Within 15 days of the money being released, the IRS will send a letter informing you of the amount and where it was sent. If there is an issue with your payment, like it never arrived or went to a divorced spouse, the letter will include a phone number where you can call to resolve the issue, but unfortunately, the IRS is difficult to communicate with in general.
Required Minimum Distributions from IRA Accounts Suspended
For the tax year 2020, there are no required minimum distributions (RMDS) from IRA accounts. If you have already withdrawn your RMDs for 2020, you cannot undo that. If you haven't taken your RMD yet, consider how delaying or withdrawing your RMD will affect your income tax brackets. For inherited IRA accounts required withdrawals are also eliminated for the 2020 tax year.
Corona Virus Distributions from Qualified Retirement Plans
Distributions of up to $100,000 from any IRA, 401k, 403b, or other qualified plan will not be subject to the usual 10% early withdrawal penalty for those who are infected with the COVID virus, have a family member infected by the virus, or were laid off or lost wages due to the virus. The distribution is still taxable, but the income, by default, will be spread over a 3-year period. This can help you access funds without bumping yourself into a much higher income tax bracket. It could potentially be used to advance fund Roth IRA conversions. More on that as we have time to digest all the ins and outs of the legislation.
The law also allows for repayment of any qualified plan distributions over a 3-year period as a qualified rollover contribution. So, if you need the funds now and are re-employed later, you will be able to replace the funds, offsetting any potential tax bracket increase in the future.
Allowable loans from qualified plans, such as a 401ks, are also increased to $100,000 or 100% of the vested account balance, whichever is lower. Repayment of any loan taken in 2020 can be delayed for up to one year.
Charitable Contribution Deduction
After the recent Tax Cuts and Jobs Act (TCJA), many taxpayers found themselves using the increased standard deduction and no longer itemizing on their income tax return. That eliminated the charitable contribution deduction. One of the permanent changes the relief bill provides is a new above the line deduction for up to $300 of cash contributions to a qualified charity. This does not include contributions to donor advised funds.
*Again, this is a preliminary look at the relief bill, we will provide updates and corrections as new information becomes available
What's the Problem?
IRAs that will be inherited by anyone except a spouse, minor children, beneficiaries with disabilities, and anyone who is ten years or less younger than the IRA owner, are now to be completely distributed over 10 years, rather than the lifetime of the heir.
Why is this a Problem?
With a shortened time span to distribute inherited IRAs, taxable income generated from an inherited IRA, in addition to one’s normal earned income, can cause uncharacteristically high tax bills if appropriate tax planning is not executed. In larger inherited IRAs, tens of thousands of tax dollars are at stake.
What are some Solutions to the SECURE Act?
Tax Planning for the SECURE Act
With the passage of the SECURE Act, stretch IRAs became a thing of the past. Rather than allowing beneficiaries to withdraw funds based on their life expectancy, the Act requires IRA beneficiaries to make a total distribution of all funds from the IRA within 10 years, with limited exceptions for spouses, minor children, beneficiaries with disabilities, and anyone who is ten years or less younger than the IRA owner.
Congress passed the Act knowing the net effect would be higher income taxes to most IRA beneficiaries. According to the Congressional Research Service, the elimination of the stretch IRA alone has the potential to generate about $15.7 billion in tax revenue over the next decade. For many beneficiaries, the inherited IRA will come during their peak earnings years when their income tax rate could be at a maximum. The effect of high earnings and additional taxable distributions from a Beneficiary IRA could cause the net value of the IRA to be reduced by 30% or more. To minimize to tax bite of an IRA inheritance, both the original IRA owner and the beneficiary will need to do diligent tax planning.
How IRA Owners can Minimize Taxes from the SECURE Act
Roth IRA Conversions
Now, more than ever, converting Traditional IRAs to Roth IRAs should be examined. We strongly believe almost everyone should convert enough funds from a Traditional IRA to a Roth IRA to fill the 12% income tax bracket each year. 12% is a fair tax rate for most taxpayers and it’s much easier to implement effective tax planning for inherited Roth IRAs than for inherited Traditional IRAs.
Having assets in a Roth IRA has advantages for the original IRA owner as well. It will reduce the amount of required minimum distributions (RMDs) when you reach age 72 (up from 70 ½, a positive from the SECURE Act), as well as provide more flexibility in managing your income-tax rate in retirement. For a free Roth conversion flow chart that will help you understand how a Roth conversion can work for you click here.
While we usually don’t recommend going beyond the 12% bracket for Roth conversions, there could be certain circumstances where that might be appropriate. For example, if you don’t need the assets in your Traditional IRA for your retirement lifestyle and all of your heirs are high wage earners, it might be better for you to pay a 22% tax rate now rather than leaving the IRA to an heir who may be taxed 32-40% on those same assets.
Naming Grandchildren as Partial IRA Beneficiaries
If you have grandchildren, including them as partial beneficiaries of your IRA can potentially increase the net value of an inherited IRA. For example, suppose you have a $500,000 IRA, two children, and four minor grandchildren.
Both children and their spouses work and earn $150,000 per year in combined taxable income, so under current income tax law that puts them in the 22% marginal Federal income tax bracket. With a Beneficiary IRA of $250,000 each, if they take equal distributions from their Beneficiary IRA of $25,000 per year for 10 years, they will be pushed into the 24% bracket and thus nearly every dollar distributed from the Beneficiary IRA is taxed at the 24% level. Or worse, say they wait to take the full $250,000 distributions in year 10 or another single year—they would jump into the 32% Federal tax bracket.
To steer some IRA assets away from being taxed at those higher tax brackets you could earmark a portion of the IRA to go to each grandchild. Under current rules, any minor can have $1,100/year of unearned income with no income tax liability. This kiddie tax rate applies to children under the age of 19 and college students under the age of 24.
Every year $1,100 is distributed from your grandchild’s inherited IRA tax-free, resulting in a savings of $242 each year the child qualifies. If the child has earned income during their teen years, the distributions can be increased to fund a Traditional IRA or Roth IRA for the child’s benefit. Smart tax-planning could combine Traditional and Roth IRA contributions to eliminate all taxes on the child’s earnings. Once the child reaches the age of majority, the ten-year rule begins. It is unlikely the grandchild’s earnings will place them in a top bracket fresh out of school, so the strategy of offsetting distributions with tax-deferred savings could allow your grandchild to build a nice retirement nest egg without much loss to income taxes.
To accomplish this, you must be sure to name a custodian for the minor grandchildren since minors cannot make financial decisions for themselves. The custodian could be a parent, but one must be named. Another important factor in determining the dollar amount that should be allocated to a grandchild is the age of the grandchild when they receive the Beneficiary IRA.
Most IRA owners will name a spouse as a primary beneficiary and that is perfectly fine. Spouses are exempt from the ten-year distribution rules. Children are generally named as contingent beneficiaries, in some equitable percentage of the account value. Most custodians only allow for simple percentage distributions to be named beneficiaries and that could create some problems. For complex beneficiary strategies, using a pass-through trust might be a better solution.
Using Pass-Through Trusts Correctly
If you’ve already established a trust as the beneficiary of your IRA, it is imperative that you review and update that trust. Most trusts have language that instructs the trustee to pay out the required minimum distribution (RMD) to the beneficiary each year. Under the SECURE Act, there are no annual RMDs until the end of the 10-year term, then the required distribution is 100% of the account value. This is a tax time bomb just waiting to explode.
At a minimum, you must rewrite the trust to allow flexibility for distributions, which also provide flexibility for income tax planning for the beneficiary(ies) of your IRA. Realizing a $500,000 Beneficiary IRA distribution through a trust in one single year will likely subject the distribution to the maximum income tax rate of 37%, plus a 3.8% Medicare surtax on some of the recipient’s income. This is just for the Federal level taxes; add in state income taxes and the beneficiary may only end up with 50% of the original account value-- certainly not what you had in mind when you drew up the trust.
Most IRA custodians do not allow for complex IRA beneficiary schemes, so the ability of pass-through trusts to manage distributions to multiple generations becomes much more important. Through a trust you can establish custodians for minor beneficiaries, name an investment and income tax counselor, and provide for flexibility in the timing of distributions during the 10-year window allowed under the SECURE Act, or even longer in the case of minor children. Although establishing the trust incurs more expense and investment of time and thought, the result can certainly provide enough benefit to owners of substantial IRA assets and their families to make it worthwhile.
How Beneficiaries Can Reduce Taxes from an Inherited IRA
Off-Setting Distributions with Tax-Deductible Savings
For many Beneficiary IRA owners, the biggest tax planning opportunity will be to simply manage the distributions over the 10-year period. One strategy would be to offset the taxable Beneficiary IRA distributions with additional tax-deferred savings. To do this, simply increase savings to an employer’s retirement plan such as a 401k, 403b, or other tax-deferred plan, or establish and contribute to a separate deductible Traditional IRA or self-employed retirement plan of your own. Any form of tax-deductible contribution will reduce the impact on income realized from one’s Beneficiary IRA dollar-for-dollar.
Let’s go back to our previous example with the $500,000 IRA. If the IRA owner’s children in this illustration are like most investors, they only contribute about 5% of their salaries to an employee retirement plan in order to maximize the company matching formula-- a.k.a get the free money. This means the parents are likely contributing much less than the $19,500 maximum salary deferral allowed by the IRS.
Let’s assume the decedent’s children can defer an additional $15,000 for each spouse in their employer 401k plans. If they defer the additional $30,000 in one year, they can distribute another $30,000 from their Beneficiary IRA(s). This results in a wash for $30,000 of distributions from the Beneficiary IRA as it would swap funds from one tax-deferred account to another and fulfill the original IRA owner’s estate planning intent.
Inherited Roth IRAs
While inherited Roth IRAs are easier to manage from an income tax perspective, you should put some thought into the options. The most obvious option is to do nothing until the final day of the ten-year withdrawal period and then take a distribution of the entire account. This maximizes the tax-free growth of the inherited Roth IRA and because the distribution is tax free, has no effect on the recipient’s tax rate.
If the beneficiary is not making maximum retirement plan contributions when they inherit the Roth IRA, taking distributions along the way and using those funds to fund their own Roth IRA, or even better-- make contributions to a Roth 401k-- could mean you really do get to stretch the inherited Roth IRA over your lifetime. Non-deductible 401k contributions, up to the annual $19,500 limit, will work as well. When you retire, the non-deductible contributions, but not the earnings, can be rolled over into your own Roth IRA. Taking money from one pocket and moving it to the other pocket, that has no hole in it, (i.e. tax-free) makes a lot of sense.
The Role of Your Financial Planner
The SECURE Act makes working with a financial planner more important than ever before. Earning an 8% or even 10% return on your investments pales in comparison to shielding 30% or more of your assets from the ravages of our income tax system. To get started on a plan to preserve your IRA assets, click HERE.
With the end of the year approaching, now is the time to look for opportunities to save on income taxes. Here are some items you should look for:
You’ve inherited an IRA- so what happens next?
Before we start, we need to understand some key terms:
Required Minimum Distribution (RMD):
The dollar amount the IRS requires one to distribute from IRAs and defined contribution plans like 401(k)s and 403(b)s. This amount is distributed from your IRA and taxed as normal income unless that distribution comes from your basis or from a Roth IRA.
This dollar amount is determined by the IRS’ Single Life Expectancy Table. You can always distribute more than the Required Minimum Distribution, but never any less. Failure to distribute the required amounts results in a sever 50% penalty. If your RMD was $10,000 and you took nothing, the IRS would penalize you $5,000!
IRS’ Single Life Expectancy Table
The table is created by the IRS to calculate how much of your IRA balance needs to be distributed each year. The table can be seen here. There are rules that govern which life expectancy age an owner or beneficiary must use in this calculation, which we will discuss.
Starting The Process
When it’s time to start the transfer process, you’ll first setup a Beneficiary IRA to hold the inherited assets. This Beneficiary IRA cannot be co-mingled with any other IRA, retirement plan, brokerage account, etc. Remember, understanding the IRS will require you to distribute some of your inheritance and knowing how that distribution is calculated is crucial in determining how to structure your Beneficiary IRA.
With your Beneficiary IRA established the IRS gives you a few options on how you can distribute the assets:
Cash Out Everything
You can take the money- but don’t run. The lump sum distribution will be taxable income and may bump you into a higher tax bracket. When April rolls around you can expect a higher tax bill from the large distribution.
Distribute Everything in 5 Years
You can take withdrawals as you please, so long as the entire IRA balance has been distributed by December 31st of the 5th year after the original IRA owner’s death. Each distribution will be taxed as normal income, so again- tax planning is crucial.
Take RMDs Based on Your Life Expectancy
If the IRA owner has not started taking RMDs or your life expectancy is longer than the IRA owner’s, use your age in the year following the year the original IRA owner died (i.e. owner dies in 2018, you would use your age in 2019 to determine the RMDs for 2019). This is especially useful for heirs who are much younger than the original IRA owner, keeping more tax deferred income and growth in the Beneficiary IRA for a longer time.
Take RMDs Based on IRA Owner’s Life Expectancy
This only applies when your life expectancy is less than that of the IRA owner’s. You use the life expectancy table based on the deceased’s age rather than your own. All distributions are taxed as normal income.
Take RMDs Based on the Oldest Beneficiary’s Life Expectancy
Only applicable with more than one beneficiary and only if no separate Beneficiary IRA accounts are setup for said beneficiaries by December 31st of the year following the IRA owner’s death. Using the oldest beneficiary’s RMD schedule for all other beneficiaries. This could be a major negative for a younger heir. Again, all distributions are taxed as normal income.
What’s Best for You?
The best thing any IRA beneficiary can do is talk with a fee-only financial adviser who will look at their entire financial picture to determine a customized strategy. Often there are further financial and tax-related issues that should be addressed when considering how to move forward with an Inherited IRA so attention to detail is of the upmost importance.
If you’re not sure what to do with an inherited IRA give us call (843.901.7778 / 843.946-9868) or shoot us an e-mail and we’ll reach out to help you navigate your Beneficiary IRA strategy.
Assets can transfer to your heirs in one of two ways when you die. They can transfer by will, which includes probate court and public filing of related documents, or they can transfer by contract.
The advantages of having your assets transfer by contract include:
Examples of assets that transfer by contract include accounts or assets titled Joint Tenants with Right of Survivorship, Transfer on Death and Pay on Death accounts, Life Insurance and Annuity contracts, Trusts, and your IRA and 401k accounts if you complete the beneficiary forms correctly.
When you first establish an IRA or 401k, an annuity or life insurance contract, you are provided a form to name beneficiaries. If you fail to complete these forms the assets will usually pass back into your estate and become part of the probate process. By naming a beneficiary or beneficiaries you can let these assets transfer by contract. You should also name contingent beneficiaries and choose whether you want the assets to transfer per stirpes or per capita. By filling out these beneficiary forms you are insuring that your wishes are honored after your death.
Many people name only a spouse as a beneficiary. If the couple have children or grand children they wish to provide for they should consider making them contingent beneficiaries to preserve the tax benefits of an IRA (however if the children or grandchildren are minors be sure a guardian has been named or the funds will be encumbered until the courts name a guardian).
Currently only surviving spouses can transfer assets from their deceased spouse's 401k to their own IRA, but the recently enacted Pension Protection Act of 2006 will extend that privilege to any beneficiary after 2007.
The bottom line is beneficiary forms are an integral and important part of your estate plan. Choosing the right way to transfer these assets can save time and money, but can also be confusing. If you are unsure how to proceed choose a professional to help you, but don't delay.
Sometimes there are good reasons to name a trust rather than an individual as a beneficiary of your IRA. Maybe you have a child who you fear will spend the money they inherit wastefully, or maybe you have a special needs heir and a direct inheritance would affect their qualifications for aid, maybe there is a second spouse you wish to provide for but children from a first marriage you want to protect also.
All of these goals can be achieved and the "stretch out" provisions of IRA rules preserved if you do some careful planning.
IRS rules only allow individuals to inherit IRAs without triggering immediate taxation. However if you structure a trust as a "see through" trust you can exert some control without losing the tax benefits of a "stretch IRA". To qualify as "see through" the trust must:
Having a trust as the beneficiary of your IRA can provide many benefits, but the price of making a mistake is high, so be sure to consult with a qualified legal and tax advisor before choosing this option.