PROTECTING YOUR RETIREMENT PLAN FROM THE NEW DEATH TAX PART 2
by: Begley Law Group
by Thomas D. Begley, Jr., CELA
The magic of a retirement account is that it permits tax-free growth over a long period of time. In the example in the previous article, the adult child had 39 years of tax-deferred growth. Under the new law, if that child were a designated beneficiary, the tax-free period of growth would be reduced from 39 years to 10 years with a significant reduction in tax-deferred growth. There are a number of strategies to deal with this problem. These strategies include the following:
- Name Eligible Designated Beneficiary. Name an EDB as beneficiary of the retirement account. The 10-year rule does not apply. EDBs include a spouse, a disabled or chronically-ill individual, an individual less than 10 years younger than the Participant, and minor children. In some cases it may make sense to leave a retirement account to a Third Party Special Needs Trust for a disabled child or chronically-ill child, and leave non-retirement plan assets to healthy children. The same considerations would apply in determining what to leave to any EDB. Leave the retirement account to the EDB and non-retirement assets to the other beneficiaries.
- Life Insurance. The Plan Participant could use RMD or could withdraw additional monies from the retirement account to replace all or part of the lost growth. In our example in the previous article, the lost growth was $1,443,649. Retirement plan money could be used during the lifetime of the Plan Participant to play premiums on a life insurance policy in the amount of $1,443,649 to replace the child’s lost wealth. Actually, since the retirement account would have income taxable to the child upon withdrawal and the life insurance proceeds would not be taxable, the same result could be achieved by purchasing less life insurance.
- Hybrid Life/Long-Term Care Insurance Policy. Long-term care has become increasingly expensive and the premiums on long-term care insurance policies have skyrocketed. Most companies that originally sold long-term care insurance have gone out of business. However, there are hybrid life/long-term care insurance policies available on the market. These policies pay a long-term care benefit if the insured requires long-term care (and there is a 70% chance that everyone will require long-term care). If the insured does not require long-term care there is a life insurance benefit. Withdrawals can be made from the retirement account to pay premiums on these policies. While long-term care insurance of some type should always be considered, it is almost essential for the parents of children with disabilities. If the parent of a child with disabilities loses a considerable amount of his or her assets by paying for long-term care, this will reduce the amount of money available to provide for the child with disabilities on the death of the parent. The child with disabilities is likely never to be able to work and the inheritance from the parent is critical.
- Roth Conversion. There are situations where it may make sense for the retired parent to withdraw money from her retirement plan at the parent’s lower income tax rates and convert to a Roth IRA. On the death of the parent, the Roth IRA would go to the parent’s child who is still working and in a higher income tax bracket, so there could be a significant tax saving. Before making a decision in this regard, it is important to obtain a detailed illustration as to how the conversion would work.
- Multiple Beneficiaries. If there are multiple beneficiaries of a retirement account, the tax on the RMD will be spread over several tax returns. The parent might consider naming children and grandchildren as beneficiaries of the retirement account. If there are four children and six grandchildren, this would be ten income tax returns that would be paying tax on a smaller distribution from the retirement account. There may even be situations where it makes sense not to name a child in a high income tax bracket, but to name grandchildren in lower income tax brackets as beneficiaries. However, it is important to understand that until a child reaches age 18, or is a dependent child under age 24, the “Kiddie Tax” applies. This means that distributions from the retirement account to the grandchild are taxed at the parents’ income tax rates, but if a child were 16 years of age, tax would be paid at the parents’ tax rate for two years and then the grandchild’s tax rate for the next eight years.
- If the Plan Participant is charitably inclined, one or more of these options may make sense.
- Charity as Beneficiary. If a charity is named as beneficiary of the retirement account the charity pays no income tax, so the money is distributed income tax-free to the charity.
- Qualified Distribution to Charity (QDC). Money can be withdrawn from an IRA in amounts not to exceed $100,000 per year and paid directly to a charity. This is called a “Qualified Distribution to Charity,” and there is no income tax consequence to the Plan Participant. This is more advantageous than the Plan Participant taking RMD and then making a charitable distribution, since the benefit of the charitable distribution is limited.
- Charitable Remainder Trust. There are two types of Charitable Remainder Trusts. One is called a Charitable Annuity Trust, and the other is called a Charitable Remainder Unitrust. Under these trusts the retirement plan can be donated to charity. The charity will then pay an income stream to the Plan Participant’s children or grandchildren over a period of many years. The charity must receive at least a 10% benefit from the trust to qualify. This is a complex strategy and a detailed illustration as to the cost and benefit should be obtained before utilizing it.