Avoiding The Five Major Threats To IRA’s: Part 4

As I have been discussing there are five threats to qualified accounts that most people don’t typically consider when doing estate planning.  The five major threats to qualified plans are unexpected loss to income taxes, excise taxes, long-term care costs (all covered previously), estate taxes (today’s topic) and to beneficiaries and/or their creditors.  As we’ve previously outlined, the threats of incomes taxes and excise taxes can easily be avoided if planned for, and the threat to long-term care costs can be planned for with the least risk by completing an IRA analysis to determine if an IRA should be liquidated or annuitized when the IRA owner becomes subject to long term care costs.  When it comes to protecting qualified accounts from estate tax, it is more challenging. 

Bigstock-Black-Bomb-With-A-Burning-Fuse-49289681If an individual dies with assets greater than $5,340,000.00 their estate is subject to a forty percent estate tax.  When this occurs, the IRA (or other qualified asset) can be subject to more than seventy five percent in total taxes.  How?  Well assuming a $1 million IRA is part of a $7 million estate, the IRA will be subject to estate tax of forty percent ($400,000.00) and upon the liquidation of the IRA by the beneficiaries it could be taxed at a rate of up to thirty nine point six percent (39.6%), which results in an additional $396,000.00 in income tax if the beneficiary is in the highest income tax bracket.  To add insult to injury, there is no deduction on the value of the estate tax return for the income tax due on the IRA.  As if federal taxes were not enough, there can be state income taxes dues when the IRA is liquidated to pay the federal estate tax. It gets even worse if you live in a state that has an estate tax.  A state estate tax is yet one more tax on top of the federal estate and income taxes, and state income taxes. Most states estate taxes are up to an additional sixteen percent.  And so the question becomes, how do you protect qualified accounts from estate tax liabilities?

The answer is you really can’t, without first liquidating the IRA and paying the income tax (other than an annual $100,000.00 gift allowed to charity).  So in order to protect IRA’s from federal and state estate taxes requires the reduction of a client’s non IRA estate during lifetime so the total estate evaluation does not exceed the estate tax limits.  One strategy to do this is annual gifting, which can be effective, but often requires a significant number of beneficiaries to distribute the annual growth on an estate of that size.  For example, if an individual had a $7 million estate and it grew at three percent the individual would have to give away $210,000.00 per year just to keep the estate from growing.  That would require fifteen beneficiaries to distribute $14,000.00 to or eight beneficiaries if the client is married. 

Another strategy to reduce estate taxes is to give away money to charity.  An individual can have the ability to benefit charities and their family by use of various strategies which is outside the scope of this writing.  A third way to reduce estate taxes is by using legal strategies to discount the value of assets by use of various tax planning techniques.  Unfortunately none of these strategies work to reduce an IRA’s value other than outright gifting after withdrawal and the payment of income tax or use of the annual allowance for distributions from qualified account to charity.  In summary, subjecting qualified accounts to estate taxes is a significant burden to the tax payer which only can be minimized by ensuring their non-qualified estate is reduced and moving to a state without income tax can reduce the income tax burden.  Obviously qualified accounts are very appealing as they have tax referral advantages, but one must weigh the long term benefit of the difference with the tax cost upon receipt or death. 

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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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