Chances are, if you hold a significant amount of money in your IRA accounts, you may have been approached by a financial professional who tells you about the “double tax” that may be a part of your account’s future. Here’s a brief explanation: when the owner of an IRA dies, assuming that the size of the estate is greater than the exclusion amount (which is a dicey question in 2010’s “limbo” for estate taxes – see below for the 2010 and 2011 specific explanations), your estate will have to pay tax on any amount above the exclusion. Presumably this includes your IRA account… and THEN, when your heirs begin taking their Required Minimum Distributions from the IRA account, they will have to pay ordinary income tax on the amounts that are distributed. Hence the term double tax.
It’s a real situation that could happen – you should be aware of it, if you happen to be in that position… and you should also be wary of any financial professional who claims that you can avoid the double tax by taking your money out of the IRA. Typically this pitch is designed to sell you an immediate annuity or some other form of annuity product. The problem is, pulling the money out of the IRA does nothing to eliminate the double tax.
In fact, what this does is to accelerate the process and cause you to pay one part (the ordinary income tax) on the distribution up front. Plus, this is usually pitched as a lump sum maneuver, which increases your taxable income and thereby increases the rate at which your distribution is taxed. Clearly, if someone tells you that pulling all your money out of your IRA will avoid the double tax situation, you should walk away and don’t look back.
Instead, if this double tax is a concern for you – that is, if your estate is large enough to be impacted by this – it makes good sense to review the entire potential estate and consider planning out your distributions to your heirs. A gifting plan, along with appropriate trust mechanisms, can possibly reduce your gross estate below the exclusion level. This could have the effect of eliminating any double taxation issues in advance, and is truly the only way to possibly avoid the dreaded double tax.
2010-Specific Situation
As the law is presently in force, there is no estate tax for 2010. Because of this, the double tax situation doesn’t apply. At the death of an IRA owner, the IRA begins distributing to the heirs as required (see this article for more information), but no estate tax is owed on any part of the estate. The “step-up” or basis carryover provisions do not apply to IRAs, other than the basis referring to any part of the IRA assets that were attributable to after-tax, non-deducted contributions or rollovers.
It’s possible that the law may be changed soon, and possibly changed retroactive to the first of the year, so stay tuned…
2011 and beyond
As the law is presently written, beginning in 2011 the estate tax exclusion is $1 million, and step-up of basis is back in force. Again, if the funds are in an IRA, there is no step-up, although as noted before, basis of after-tax contributions and rollovers remains intact.
So if your estate has the opportunity to be greater than $1 million in value, any amounts above that exclusion amount will be subject to estate tax. If those assets that are above the exclusion amount include your IRA, then your heirs will also have to pay ordinary income tax on the distributions – effectively paying tax again on the same money, the double tax.
As you can see, with the 2011 law, it doesn’t take long to have an estate that is possibly impacted by this double taxation situation, so it would likely make sense to review your overall estate plan and determine if there is a way to avoid the tax on some part of your estate.
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I can learn from you, you can learn from me - please leave your comments and links!Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry. . Read more from this author
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Thanks for sharing this, Jim.
Especially with larger retirement accounts, this is another reason why people need a coordinated estate plan to account for all their assets and accommodate the unique characteristics of tax-deferred accounts like IRAs.
And regardless of IRA account balances, I think that you’ve provided good motivation for people to regularly review their beneficiary designations to make sure their wishes will be carried out given the current legislation, etc.
Great information