The problem with taxes and inheritance is often misunderstood. After all, an inheritance is a gift, so why should anyone worry about having to pay taxes on a gift? The problem isn’t one of having to pay the taxes; it’s when they come due.
The money that you have been tucking away into your traditional IRA or other retirement-savings vehicle has enjoyed tax-deferred growth. These accounts are built up using money that came out of your paycheck before the taxes were paid. Eventually, those taxes have to be paid, either by you or by someone else such as your spouse, your children, or your grandkids.
The question is, will your kids have to pay your tax bill all at once, or over a period of many years? This is the vital distinction to be made, and it is a problem that proper tax planning can solve with relative ease. The real gift to your loved ones isn’t just a reduced tax bill, however, but a larger overall inheritance.
WHY IT HAPPENS
The IRS isn’t going to wait around forever to collect on the taxes you owe inside of your IRA or tax-deferred account. They have a published set of guidelines that explains when they want you to start taking this money out. This mandatory withdrawal, known as your Required Minimum Distribution or RMD, applies to both IRAs and defined-contribution plans such as 401(k)s.
Your RMD is an amount calculated by the IRS that uses your age and average life expectancy rates to set up a payment schedule of the taxes you owe, so it falls within a reasonable time frame. The absolute latest you can start paying those taxes is the age of 70 ½.
When you pass away and leave your IRA to your beneficiaries, they will inherit your tax debt. Not only do they have to pay the taxes on the money that you earned, but they have to pay it according to the federal guidelines of your life expectancy, not theirs.
WHAT TO DO
When your child or grandchild inherits your IRA, as a non-spousal beneficiary, she will be required to take distributions out within five years of inheriting. Even if she rolls that inherited money into her own IRA, that money still becomes taxable. That means she could have thousands of dollars in taxes due come April. There is a way to avoid this.
A Stretch IRA isn’t a new kind of IRA, but rather it’s a benefit of the tax code. Both traditional and Roth IRAs can be stretched. You can work with a qualified financial advisor to set up your IRA correctly so that when your daughter inherits, she can’t make the mistake of doing the wrong thing with the money. The Stretch option structures the inheritance for her so the money continues to grow, and the taxes are due according to the tables of her life expectancy and not yours. This means a tax schedule that is manageable and, ultimately, more money for her.
The question that proper tax planning answers isn’t who will pay, but rather when. With a little planning, it’s possible to grow and stretch the amount of money your loved ones will receive without it having to cost you anything extra. Ask your financial professional if a Stretch IRA is right for your situation.