There was, and continues to be, a great amount of confusion regarding the estate tax implications of individual retirement accounts, including IRAs, Keough Plans and 401(k) plans.
As most people realize, these accounts contain income that was not subject to tax when originally earned, together with appreciation that has been accruing each year in these accounts on a tax-deferred basis. At death an IRA, or other retirement account, is included in the decedent’s estate and is subject to estate tax just like any other asset. However, the problem with an IRA is that while it is subject to estate tax, it is also subject to income tax when it is drawn down by the designated beneficiary other than one’s spouse.
An IRA is not bequeathed by a will or trust. Rather, it is bequeathed in the same fashion that a life insurance policy is transferred, namely by designating a beneficiary. Thus, when an IRA is created, or any time after that, a beneficiary or beneficiaries must be designated in writing by the person who “owns” the IRA. The beneficiary will only inherit the account when the owner of the IRA dies.
Let us assume that the taxpayer has designated his or her surviving spouse as the beneficiary of the IRA and thus, the surviving spouse will receive the benefits of the IRA outright and not in trust upon the death of the taxpayer. In most cases, the surviving spouse is entitled to collect and “roll over” the entire IRA account into a new spousal roll-over account. This is an exception to the general rule. A surviving spouse is the only person who can roll-over the IRA into a new IRA account. By rolling over the account, all income tax is deferred until funds are drawn down by the surviving spouse from the new roll-over account.
In addition, because the asset is passing from the decedent to his or her surviving spouse, the IRA account will then qualify for the estate tax unlimited marital deduction. Thus, with minimal planning, the IRA account when it passes from taxpayer to his or her spouse, will be free of all income and estate tax. Of course, when the surviving spouse begins to draw down from the roll-over IRA account those funds will be subject to immediate income tax in the hands of the surviving spouse.
The problem is usually when there is no surviving spouse and the taxpayer wishes the IRA account to pass to his or her children. At this point the beneficiary should be changed so that it passes in equal (or unequal) shares to the children. Upon the death of both parents the account will then be subject to estate tax in the estate of the last of the parents to die.
Generally, if a “special election” is made then upon the death of the surviving parent, the children may then draw down the account over their own life expectancy if they so choose. The benefit to this is that while a small amount is drawn down each year, the account continues to grow on a tax-deferred basis.
Because an IRA account is subject to both estate and income tax, a large percentage of the account can be lost when these accounts pass from parents to children. One way to preserve these assets for the children is to utilize life insurance. The easiest way to do this is to have the taxpayer who is taking the minimum distributions from his or her own IRA account to make withdrawals from the IRA in greater amounts. After putting aside the appropriate amounts to pay the income tax, the taxpayer should then consider using those extra after-tax dollars to buy life insurance (in an appropriate life insurance trust) for the benefit of the children. The idea is to convert an asset which is subject to double taxation into an asset which is free of all estate and income taxes.