Expensive House

Planning for Losses Due to Taxes

At the death of the primary owner of a retirement account, the beneficiary of that account must be determined. If the beneficiary is a spouse, he or she makes an election on how to receive the proceeds from the account. Often times, the spouse elects to maintain the account as it is, but now the account is treated as the survivor's IRA. This ensures that the income flowing out of the account will last throughout the length of the surviving spouse's retirement. The unlimited marital deduction can be used to shelter the transfer to the spouse from any estate tax.

The death of the second spouse is decidedly different. There is no longer an unlimited marital deduction available (unless the surviving spouse has remarried), so only a single exemption is available to shelter assets from estate taxes. If the estate is larger than this, a concern arises regarding how to pay off the taxes and other expenses of the estate. The retirement account is an easy source to access, but not necessarily the most financially efficient vehicle to use. The RMD rules permit beneficiaries to receive monies from qualified plans and IRAs over their lifetimes. By retaining the money in the account, the compound interest element will permit the account to grow dramatically over the beneficiary's lifetime, even as annual distributions are made. Distributing the IRA money to pay off the expenses not only reduces the account balance, but also cuts off the benefit of the compounding interest that has accumulated up to this point.

To best allow the funds maintained in the IRA or qualified plan to grow, the survivor should use a separate source to pay off the taxes and expenses. How can you create a separate source of funds to pay off the taxes and other expenses? Loans are one option. Perhaps personal accounts may be utilized.

One truly cost-effective means to pay the debt off is life insurance. Survivorship life insurance placed into an Irrevocable Life Insurance Trust (ILIT) can guarantee funding is available while ensuring that the insurance policy purchased remains out of your estate.

Consider this case study:
George has a $5 million estate, with $2 million in his 401(k). He is married to Jane and has one child, Edward. Jane is the sole beneficiary on his 401(k). George takes only his required minimum distributions as income to support his lifestyle. George dies in 2008, and Jane, the beneficiary, then begins receiving the payouts. At this point, taxes shouldn't be too big of a concern. The Federal estate tax can be avoided by utilizing the unlimited marital deduction, and Jane's income tax liability should be approximately the same as is was prior to George's death, as they are being reported on the same tax return.

Jane is now taking the required minimum distributions, and has named Edward as the beneficiary of the account. Everything is fine until 2015, when Jane dies. Now what does the taxation look like? Jane's estate may be as high as $7 million, resulting in millions of dollars in estate taxes. $3.5 million of this is wrapped up in the qualified plan. Can Jane's estate pay off the tax? Not likely. If the funds in the qualified plan are used, the potential growth is stymied. To avoid this outcome perhaps life insurance is the way to go.


This Web site is intended for general information purposes only. It does not nor is it intended to constitute legal, tax or investment advice. United Financial Systems, Corporation is not a lawyer, registered investment advisor or investment advisor representative, and is not engaged in the practice of law or the business of investment advice.