IRAs, Taxes and Estate Planning 2023

Estate planning is more than wills and powers of attorney. It’s having some control over what happens to your assets when you pass on. One of the most commonly used retirement savings plans, after 401(k)s, are IRAs. Many folks will pass away with assets in their IRAs yet most of us don’t think of IRAs as a part of our legacy.

Traditional IRAs — Taxes During Life

In most cases, there’s no federal income tax paid on contributions to the IRA and the funds grow without income tax due. Taxes are paid when the money is withdrawn on the entire amount withdrawn (unless you made contributions after paying taxes on the money). If you reach age 72, current Federal tax law requires you begin taking distributions no later than April 1 following the year you turn 72 (73 if you reach age 72 after Dec. 31, 2022). According to the IRS FAQ linked above, account owners in a workplace retirement plan (for example, 401(k) or profit-sharing plan) can delay taking their “Required Minimum Distributions” (RMDs) until the year they retire, unless they're a 5% owner of the business sponsoring the plan.

ROTH IRAS are funded after you’ve paid income tax but your money grows free of income tax. Roth IRAs do not require withdrawals until after the death of the owner. Designated Roth accounts in a 401(k) or 403(b) plan are subject to the RMD rules for 2022 and 2023. For 2024 and later years, RMDs are no longer required from designated Roth accounts. You must still take RMDs from designated Roth accounts for 2023, including those with a required beginning date of April 1, 2024.

If you don’t take enough in withdrawals, a severe penalty will be due. For example, if the RMD for this year is $20,000 but only $12,000 is distributed from the IRA, a penalty tax of 50% or $4,000 must be paid on the $8,000 that wasn’t distributed ($20,000 - $12,000 = $8,000 x 50%). If you’d like to figure out your RMDs, click here to download an IRS worksheet.

Important Factors to Keep In Mind:

• Financial institutions must report IRA required minimum distributions to the IRS.
• Receiving additional taxable income from IRAs may affect your tax bracket, income tax due on Social Security benefits and even Medicare premiums (affecting IRMAA surcharges for higher income brackets).
• You can withdraw more than your minimum but remember that it will increase your income in the year you withdraw it.
• If you delay your first RMD until sometime between January 1st and April 1st of the year after you turn 72, you will then have two distributions in the same year, compounding the tax and Medicare premium impact.
• Up to one million dollars of IRA assets are protected from bankruptcy. That value is adjusted for inflation/deflation annually since inception in 2005.

ROTH and Traditional IRAs — Taxes for Beneficiaries

Whether you choose to take only Required Minimum Distributions (RMDs) or to take a different amount, you may end up with money in your IRA when you pass. Both ROTH and Traditional IRAs allow for you to specify beneficiaries. If you do not specify a beneficiary, that money will go to your Estate which may result in less advantageous tax and distribution outcomes.

By naming your beneficiary or beneficiaries, you control where that money goes. You will typically have three types of beneficiary options:

• Primary Beneficiaries: Your first choice for remaining funds to be distributed to.
• Secondary Beneficiaries: Your backup beneficiaries if primary beneficiaries pass away before you.
• Final Beneficiaries: Backup for primary and secondary beneficiaries who don’t survive you.

You can name different beneficiaries for each IRA you own. In some situations, you may even want to name a trust as a beneficiary. Trust can give you some control on how your beneficiaries use their inheritance. Consider a Trust in the following situations:

• A marriage includes children from prior marriages.
• A child or grandchild has impaired judgment, is disabled, or has a drug or alcohol addiction.

Beneficiaries of a traditional IRA will owe income taxes when money is withdrawn from the inherited traditional IRA. ROTH IRA deposits can generally be withdrawn without income tax costs. Growth on ROTH IRA funds are typically tax free after the ROTH IRA is 5 years old. It’s possible to withdraw earnings last to reach the tax free term of the ROTH IRA.

Most beneficiaries of IRAs generally have 2 distribution choices:

• Immediate Lump-Sum Distributions. The entire value of the IRA can be distributed all at once to the beneficiary. Traditional IRA distributions are of course included in the beneficiary’s income for the year. ROTH IRA withdrawals are NOT taxable income in most situations. Be aware of the potential impact of a lump-sum withdrawal on income tax bracket, social security benefit taxes and IRMAA surcharges on Medicare premiums.
• Distributions Over Ten Years. As long as all the funds are distributed by the end of 10 years after the original IRA owner’s death, withdrawals can be any amount any year. Taxes will be due on the taxable portion in the year they are received.

Spouses who are sole beneficiaries have special treatment when they inherit your IRA. NOTE: Do NOT include any other beneficiaries besides your spouse in the Primary Beneficiary category if you want them to qualify for these options:

• Your spouse, as sole beneficiary, has the option to claim the IRA as their own. The regulations governing taxes, withdrawals and RMDs would then be based upon your spouse's age instead of yours.
• Assets continue to grow tax-deferred.
• Distributions may be subject to penalty taxes if withdrawn before they turn 59 ½.
• RMDs on traditional IRAs would not be due until THEY turn 72 and distributions would be based upon their life expectancy.
• ROTH IRA funds can be left in the ROTH IRA indefinitely.
• Or the assets can be transferred to an inherited IRA in your spouse’s name.
• Assets continue to grow tax-deferred.
• Early distribution penalties and RMDs are based on YOUR age, not your spouse's. For example, RMDs on Traditional IRAs must still be taken by April 1st of the year following the year in which you would have reached 72, not when your spouse reaches 72.
• ONLY spouses may roll inherited IRAs into their own IRA to gain bankruptcy protection.

“Eligible designated beneficiaries” can extend the length of time they have to receive distributions by taking required minimum distributions based upon THEIR life expectancy. In 2020 the SECURE Act modified these rules, so be sure to consult a professional CPA or estate attorney if in doubt.

• Disabled - qualified under strict IRA rules
• Chronically ill
• Minor children (not grandchildren) to the age of majority for the state they live in. Once they attain majority, the rest of the IRA must be distributed by the end of 10 years.
• Not more than 10 years younger than the deceased IRA owner (Likely to have been modified by the SECURE Act.)
• Certain Trusts (Likely to have been modified by the SECURE Act.)

Be aware that if the beneficiary is no longer a minor child, chronically ill or qualified as disabled under strict IRS rules, they lose this extended distribution benefit.

NOTICE: In order to avoid unforeseen and/or negative tax consequences and, possibly, creditor protection consequences, an IRA owner and beneficiary should consider seeking professional tax advice.

Strategies To Turn Traditional IRAs Into Benefits For Loved Ones or Charities

If you’re one of those fortunate people with a traditional IRA you don’t need for retirement income, you may wish to do more with the assets to benefit your loved ones or favorite charities. You may want to choose one of the following options to maximize your legacy:

• Purchase Life Insurance. After-tax value of Required Minimum Distributions can be used to purchase permanent life insurance based on your life.
• Permanent life insurance will offer tax-free growth plus tax-free pay out to your beneficiaries.
• You can also make a Trust the beneficiary to offer you more control over how the inheritance is spent.
• Make Charitable Contributions. Once you reach age 70 ½, you can make tax-free charitable distributions of up to $100,000 from traditional IRAs directly to charities. After age 72, those distributions can be made as “qualified charitable distributions”, which count towards your Required Minimum Distributions.
• Ensure the donations are made from the IRA trustee to a qualified public charity. Donor-advised funds and private foundations do not qualify.
• Charitable distributions do NOT affect tax brackets, Social Security taxes, or Medicare premium IRMAA surcharges.
• Make sure you have a receipt from the qualified charity and use the proper line to report your contribution. (SEE IRS link above for details.)

Next Steps:

Hopefully the information presented here sheds new light on IRAs as a part of a thorough estate plan. If you’re interested in making your estate planning more robust, check out LegacyLock through our free trial offer. (We’re happy to give you a tour if you prefer.) To stress test your retirement plan, pick a time to meet with one of our specialists to set up your Retirement Analyzer profile.

P.S. Learn More about ways life insurance can protect you from taxes.

U.S. Treasury Circular 230 may require us to advise you that "any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor."

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