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Could you lose over 80% of your
IRA to taxes when you die? Yes, unless you act before it’s
too late. Read on to find out if this affects you and how
you can minimize the effect of taxes on your IRA.
You’ve worked hard all your life and enjoyed a successful
career. Along the way, you’ve sacrificed to put money into
retirement programs, building a nest egg to provide for you
and your family the rest of your life. If you live just off
the interest, you can leave a nice inheritance for your
children.
Unfortunately, Uncle Sam could take over 80% of it in taxes,
leaving your children with much less than you expected. If
you owe estate taxes at your death and haven’t planned
properly, your children may be forced to tap into your
retirement accounts. This could result in 35% being lost in
income taxes on top of 48% being lost to estate taxes!
There are two kinds of taxes that affect IRAs and other
pre-tax accounts. The first is income tax. When money is
withdrawn from these pre-tax accounts, ordinary income tax
is paid on the full amount withdrawn. Withdraw $50,000 from
your IRA, pay income taxes on $50,000.
Since IRAs and other retirement accounts have a beneficiary
and, typically, are not subject to Probate, many people
think they’re not subject to estate taxes. That’s wrong. The
full value of these accounts is included in the value of
your estate and may be subject to estate taxes.
What’s worse, the value of your estate isn’t reduced by the
income taxes due if you pull money out of these pre-tax
accounts. For instance, let’s say you have $1,000,000 in an
IRA. Even though you would only have about $650,000 if you
took it out and paid income taxes on it, the full $1,000,000
might be subject to estate taxes.
Each of us has an estate tax exemption of $1,500,000 for
2004. If you’re married, that means you and your spouse
should be able to pass on $3,000,000 before worrying about
estate taxes. But couples with smaller estates can still end
up paying estate taxes.
For instance, Bill and Sue are happily retired. Bill retired
and rolled $1,000,000 into a Traditional IRA. Sue also had
an IRA worth $500,000. They owned a home and other real
estate bringing the value of their estate to $2,500,000.
Since his IRA would be his wife’s main source of income when
he died, Bill named Sue as his primary beneficiary. He
passes away and also leaves the rest of his share of the
estate to Sue. There aren’t any estate taxes or income taxes
on transfers between spouses.
The problem occurs when Sue dies. The value of the estate is
$2,500,000. She can only pass $1,500,000 free of estate tax.
The result is roughly $500,000 in estate taxes must be paid
9 months after her death.
Since the IRAs are the only source of readily available
funds, the children withdraw money from Bill’s IRA. This
means that almost $350,000 more is due in income taxes.
How are they going to pay those additional income taxes? By
taking more money out of the IRA. So the have to pay even
more in income taxes! Ultimately, very little of the IRA is
left for the children.
What can you do if your largest asset is an IRA and you face
a similar situation? You can reduce the amount of estate
taxes owed through the use of special trust vehicles.
Additionally, the portion of an IRA or estate that is not
left to a surviving spouse counts toward the decedent
spouses’ exemption, so leaving a portion of an IRA to a
child instead of a spouse can reduce estate taxes.
Life insurance can be used to provide the liquidity needed
so that the children don’t have to tap the IRAs for funds to
pay the estate taxes.
Consult with a qualified professional to properly take
advantage of these complex strategies. But act now, because
these strategies are only effective while you are still
alive.
I regularly respond to readers email, so if you have
questions about this or other financial topics, submit your
questions at
www.guardingyourwealth.com/askjeff.htm.
Mr. Voudrie is a Certified Financial Planner, a nationally
syndicated columnist and the President of Legacy Planning
Group, Inc., a Private Wealth Management firm in Johnson
City, TN. For more information call 1-877-827-1463 or visit
www.guardingyourwealth.com.
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