When your beneficiary inherits your tax-deferred retirement plan (whether it’s a 401(k), IRA, 403(b), or SEP) after you pass away, they are required to pay taxes on all the money they receive. These taxes, which could include Income Taxes, Estate Taxes, and IRD Taxes (Income in Respect of a Decedent Taxes), can cost the beneficiary up to 40% of the total value of the retirement plan. Unfortunately, you can’t eliminate these taxes. You can, however, learn how to reduce income taxes with the help of an experienced attorney.
How to Reduce Income Taxes with a “Stretch Out” Plan
One way to reduce the drastic effects of tax and to leverage the retirement plan asset for the future is for the beneficiary to “stretch out” the inherited qualified plan over their lifetime. The IRS will allow the beneficiary to take required minimum distributions based on their life expectancy at the time they inherit the retirement plan.
For example, if a beneficiary is 50 years old (with a life expectancy of 30 more years) when they inherit an IRA, they are only required to withdraw approximately 1/30th of the IRA that first year. So instead of withdrawing all the funds immediately and paying 40% in taxes on the withdrawn funds, they will take out a fraction of the total funds and only pay taxes on that small fraction. The next year, they will have to draw out 1/29th of the funds; the year after that, 1/28th. And when they finally reach the age of 80, they will have to withdraw all the funds remaining in the retirement plan. The “stretch out” plan can be very useful if you’re wondering how to reduce income tax because it allows the money in the retirement plan to grow tax-deferred. In other words, only having to take out a small percentage in those early years, means the majority of the IRA gets to grow tax deferred.
Sometimes it helps to see the numbers when we’re talking about long-term plans like this. Imagine you are the beneficiary of a $100,000 IRA that earns 8% per year. If you take out all the money right away and pay the 40% in taxes, you will only receive $60,000. However, if you use a “stretch-out” plan over the course of 30 or more years, you could grow the IRA such that the income stream would exceed a million dollars or more over the 30 year period!
Yes, the beneficiary will have to use restraint at first. It might be tempting to take all the money and run, but if they are patient and think long-term, they will see the great value in stretching out their inheritance.
This strategy also requires that your beneficiary is listed individually as your beneficiary (so you should not list a revocable living trust, for example). For an individual who wants to make sure their beneficiary avails themself to benefits of “stretch-out”, there is a type of trust (an IRA or Retirement Plan trust) that can ensure the beneficiary does the “stretch-out”, thus making sure there are resources available in your beneficiary’s retirement years. If you’re interested in this strategy and will need an IRA trust, tune in to the blog next week. We’ll be discussing why someone might want an IRA trust and how the process will change if you use one.
Finally, if you’re interested in learning more about how to reduce income taxes, inheritance taxes, estate taxes, capital gains taxes, and other taxes, and you live in Southwest Missouri, call the attorneys at Parks & Jones. Their experience in estate planning will help you protect both your estate and your family.