Under the common rules of tax law, IRA accounts can be very costly to the beneficiary of the IRA. With the exception of the surviving spouse, the remaining beneficiaries may be required to pay income tax (up to 35%) on the IRA account. How do we avoid these taxes?
Benefits of an IRA Account
Assets held in an IRA are generally very beneficial from an income tax perspective. The money is deposited into the account on a tax free basis. Then, while the assets remain in the account, the assets grow on a tax deferred basis. There is no tax on the assets in the IRA account until the money is withdrawn at retirement. At retirement, the owner of the IRA account is required to take small amounts from the IRA on an annual basis. These distributions are called required minimum distributions and must be withdrawn from the IRA once the owner reaches age 70 1/2. When the owner dies, the IRA account is owned by the beneficiary. If the beneficiary is the surviving spouse, the spouse can roll over the IRA assets into the surviving spouse’s own IRA account. There is no tax to the surviving spouse when the account is rolled over. Finally, when the surviving spouse dies, the assets are distributed to the non-spouse beneficiary. The non spouse beneficiary cannot rollover the IRA.
Choices of the Non-spouse Beneficiary
The non-spouse beneficiary has several choices when he or she receives the IRA account. The first, and most expensive choice is to cash out the IRA account. When one cashes out an IRA account, the entire amount of the IRA account is subject to income tax. The income tax can take up to 35% for income tax purposes. If there is an estate tax, (beginning 2011) the estate tax can take up to 55% for estate tax purposes. These taxes can leave very little of the IRA account in tact. The beneficiary has another choice however, The beneficiary can choose to do a Stretch or Inherited IRA. This type of IRA account stays intact. The IRA is not cashed out so there is no large income tax due. The assets can continue to grow tax deferred in the account. The beneficiary is required to take out minimum distributions each year. However, the beneficiary can take the distributions over his or her lifetime, thus creating a retirement account for the beneficiary.
Choosing the Stretch or Inherited IRA
Choosing the Stretch or Inherited IRA gives the beneficiary the opportunity to grow the IRA account over the beneficiary’s lifetime. The younger the beneficiary, the greater the lifetime benefits. The IRA assets may still be subject to estate tax (beginning in 2011), however this option should be discussed whenever one inherits an IRA. Discuss your choices with your financial or tax professional. A Stretch or Inherited IRA can be created without the help of an attorney. An educated consumer needs to consider all the available options.