IRA’s and other qualified accounts are becoming the biggest portion of many individuals' portfolios. They have many special rules to maintain their income tax advantages and despite having special rules that protect them for income tax there are several threats to them that are often overlooked by individuals and the professionals that serve them. This will be the first of a five-part series sharing the five major threats to IRA’s and other qualified accounts and how to avoid them. So what are the five major threats to retirement plans? In my experience it is: income taxes, excise taxes, long term care costs, estate taxes, and risks to beneficiaries and/or their creditors.
The first risk to IRAs, and other qualified assets, is income taxes. Many of us are aware contributions made to a qualified plan defers the income tax on the money contributed. In addition, contributions accumulate "tax free". The challenge and threat however is not upon the contribution to the plan, but the withdrawal. The presumption is the individual will withdraw the money at retirement when they are in a lower income tax bracket. That is not always true. There is a risk the individual can have a higher tax bracket after death, or that income tax rates will rise (Congress has raised rates many times in the past). Higher income tax rates later are not only caused by Congress and by the asset mix of the client, but quite often the income tax rate of the beneficiary is higher than that of the original plan owner. For example a client in retirement might be taxed at the fifteen percent tax bracket but they pass away and leave it to their children, who may be in the thirty nine and a half percent tax bracket. This is often overlooked.
The biggest threat I find however, is that many individuals who own IRAs and retirement funds, only withdraw the required minimum distribution rather than optimizing the minimum income tax overall . In many circumstances, seniors pay no income tax or only pay ten or fifteen percent. A married couple over the age sixty five can earn up to $21,850.00 (not including social security) without paying any tax and up o $40,300.00 before they are subject to taxes beyond fifteen percent. But seniors routinely take the required minimum distribution rather than taking more distributions to withdraw the most possible while keeping them in the fifteen percent tax bracket or less. The biggest advantage is the after tax money (which only between zero and fifteen percent was paid) reinvested grows and is subject to capital gains rates which is lower than ordinary income tax on an IRA if ever sold during life, and if held till after death gets “stepped up” and no income tax is paid on the growth of the assets by the kids that inherit them, If the kids hold onto them all growth is subject to capital gains rates rather than the higher ordinary income tax rates. So the alert to all is don't be on autopilot, examine your short and long term income tax rates compared to your beneficiaries, to properly decide when to take advantage of strategic distributions during life to ensure you pay the overall lowest income tax on your IRA’s.
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David J. Zumpano, Esq, CPA, Co-founder Lawyers With Purpose, Founder and Senior Partner of Estate Planning Law Center
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