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May 27, 2009

Don’t Let the IRS be Your IRA’s Largest Beneficiary

ATT00261Your IRA faces two forms of Federal taxes… income and estate tax.  Federal income taxes can be deferred by using the Stretch IRA concepts we discussed in an earlier article.  Estate taxes, however, are not so easily handled. Fortunately (or not?), most Americans do not have estate tax issues.  In 2009, estate taxes are 45% on amounts greater than $3.5 million.  In 2010, estate tax is scheduled to disappear, but then it comes back in 2011 at 55% of the assets over $1 million!  President Obama is requesting Congress to keep the Estate tax at 45% for estates over $3.5 million in 2010 and beyond. To what degree President Obama will get his way, we will have to wait and see, but it does seem likely that estate taxes are here to stay.

Double taxation?  If you are one of those lucky few who are subject to estate taxes at your death, your IRA is going to get hit with a double tax whammy.  Assets in your IRA will be subject to both income and estate taxes, possibly making the IRS your largest beneficiary.  The combined tax could be as high as 75%, and this does not include state taxes!  Your heirs will receive a mere fraction of what you worked and saved for all those years.

Let’s look at an example:   Jim and Carol Smith, ages 66 and 62.  Jim owns an IRA valued at $1 million.  They both have estates valued at $5 million each, so they are subject to estate tax.  Jim and Carol decided not to use Jim’s IRA for current income.  Instead, they use other sources of income and plan to leave the IRA to their three children and four grandchildren.  When Jim passes away, his IRA will be subject to income tax at 35% (or more depending on future tax rates), and 45% estate tax.  Jim has inadvertently
made the IRS his largest beneficiary of his IRA.

The good news is that there is a technique that can enhance the amount of the inheritance to your loved ones.  It is called the IRA Legacy Max Strategy.  This strategy can be used by anyone who wishes to provide an inheritance as large as possible for their children and grandchildren, while minimizing taxes, whether or not you have a large estate.  But for those who are subject to estate taxes, the benefits of the IRA Legacy Max Strategy are

Here is how it works.  To utilize the IRA Legacy Max Strategy, you must be in a financial position to give up at least part of the income you would have received from your IRA.  The IRA owner sets up an Irrevocable Life Insurance Trust (ILIT).  Next, the owner makes withdrawals from the IRA annually.  After paying the income taxes, the benefactor deposits part or all of the after tax withdrawal amount into the ILIT.  The trustee of the ILIT uses the proceeds to purchase life insurance on the IRA owner’s life or
on a “Joint Life – Last to Die” basis with the owner’s spouse.  At the death of the insured (or last survivor), the death benefit is paid to the ILIT. If the ILIT was established properly, the death benefit is passed to the trust, free of any income and estate taxes!  The trust can then pass the trust earnings or principal to the trust beneficiaries, as specified in the trust agreement
There are five important caveats you need to know.  First, the annual gifts to the ILIT reduce the lifetime gift exclusion of $1 million; however, gifts up to $13,000 per year, per trust beneficiary, are allowed by law, without reducing your lifetime gift exclusion.  If your spouse agrees, that amount goes up to $26,000 per year, per trust beneficiary.  Second, the ILIT must offer the trust beneficiaries the ability to remove their share of the
annual gifts.  As you will see in the example below, it is not in their best interest to do so.  Third, you will need a qualified estate planning attorney to draft your trust documents.  Fourth, you will need a trustee to oversee the trust.  And, lastly, you will need a financial advisor to make sure all the pieces of the puzzle come together correctly.

After visiting with a financial advisor, Jim and Carol decide to use the IRA Legacy Max Strategy.  They want to both minimize taxes and maximize their children and grandchildren’s inheritance.  Jim, being a conservative man, decides to reposition his IRA assets into an immediate annuity that will provide a guaranteed income for Jim and Carol’s life.  Jim has his estate attorney draft an ILIT, naming each of their three children and four grandchildren as beneficiaries.  Each child is entitled to 20% of the trust proceeds and each grandchild is entitled to 10%.  Jim has the trust constructed such that only their children and grandchildren, or their lineal decedents have any legal rights to trust proceeds.

The trustee of the ILIT, purchases a $2.5 million, “Second to Die Life Insurance Policy” on Jim and Carol.  Each year, Jim gifts part of his after-tax IRA distributions to the ILIT.  Since there are seven beneficiaries, Jim does not have to use his lifetime exemption. Each year, the beneficiaries are notified that they can remove their portion of the annual gift, but they decline to do so.  The trustee uses the proceeds to pay premiums on the “Second to Die Life Insurance Policy”.

At the death of the last surviving spouse, Jim’s IRA is valued at zero so no income or estate taxes are due.  The life insurance policy pays the $2.5 million death benefit to the trust (income and estate tax free).  The beneficiaries are then entitled to receive earnings and principal under the terms Jim specified in the trust document.  While assets are in the trust, the beneficiaries enjoy creditor protection.  The net result is Jim and Carol’s heirs receive over ten times as much inheritance by using the IRA Legacy Max Strategy than if they had just left the money in the IRA.  The only loser is the IRS, who will now be cut out of the inheritance.

Planning Pays!

Contact your Money Concepts’ financial advisor and review your IRA options. Get the information you need to know to make an informed, thoughtful decision.

P.S.  Please feel free to forward this article to anyone you think might benefit from this information.  Again, we are always interested in visiting with your referrals.  We appreciate our relationship.

Please note:  If you should make withdrawals from your IRA prior to the ageof 59½, you may be subject to taxes and penalties.