Taxation of Your Retirement Assets: Some Facts You Need to Know
Retirement plan assets are potentially exposed to a harsh, multi-pronged tax system: federal income taxes, federal estate taxes, state income taxes and state death taxes. Some people who fail to carefully plan may see these combined taxes take a substantial and unexpected toll on their retirement accumulation — hardly the reward they expected after years of hard work and sacrifice. Here is a brief overview showing how these taxes can affect your retirement account and what you can do to stop the tax erosion of your retirement nest egg.
How Much Will Be Lost to Income Taxes?
Retirement plan distributions generally are taxable as ordinary income in the year received. Under the current federal income tax laws, the marginal tax rate on ordinary income can be as high as 35 percent.
If your state and/or locality levies an income tax, the distribution may also be subject to these taxes, which could add several more percentage points to the total income tax depletion.
Moreover, “premature” distributions may trigger a ten percent penalty tax in addition to the regular income tax. A distribution is generally premature if taken before age 59-1/2, unless certain exceptions apply. A plan distribution following a participant’s death is one of the exceptions, so the ten percent tax is only a factor for lifetime distributions.
How Much Will Be Lost to Death Taxes?
If a retirement plan participant has assets remaining in the plan at death and gifts them to individual heirs (other than a surviving spouse), the remaining accumulation at death will be subject to federal estate taxation. The federal estate tax rate is 45 percent on taxable estates over $2 million (in 2008).
State death taxes can deplete retirement accounts even more at a participant’s death. Moreover, many experts think states will raise their death taxes in the coming years because of fiscal shortfalls and unfavorable changes in federal laws.
Why It Pays to Know about “Income in Respect of a Decedent”
From a tax point of view, some assets carry a heavier tax burden than others. Such is the case with those classified as “income in respect of a decedent.” If this sounds complicated -- stay with me! I will explain income in respect of a decedent, or “IRD,” which planning with for can provide important tax relief.
When your life insurance benefits are paid to your beneficiary, or you leave securities or real estate to an heir, such property is potentially subject to the federal estate tax — but not to the federal income tax. This contrasts with the treatment of certain assets that the law calls IRD. These assets are “tax-cursed” because they are potentially subject to both the federal estate tax and the federal income tax.
For example, when a distribution is made from a tax-deferred retirement account, the government “makes up” tax-wise for letting you avoid federal income taxes on (1) contributions to the plan and (2) the investment earnings inside the plan while the account was building. If this distribution occurs after the plan participant’s death, the federal estate tax may apply to the plan participant’s estate, as well as the income tax on the distribution. So, the heirs are left with the unpleasant possibility of double taxation — or even quadruple taxation when state taxes are considered.
Federal tax law allows an estate beneficiary who has received IRD to deduct the federal estate tax paid on the IRD for income tax purposes. This partially alleviates the multiple taxation problems.
Nonetheless, even with partial tax relief, IRD items are not as attractive to estate beneficiaries as other types of property which carry no income tax consequences. And, there is another important consideration: If the recipient of the IRD item is an income tax exempt charitable organization, there is no income tax liability when the IRD item is received. In addition, the estate itself can deduct charitable gifts (bequests) in computing federal and state death taxes.
So, for many people, it makes sense to —
- fulfill family bequests with non-IRD assets that do not carry income tax burdens, and
- use IRD items, such as retirement plan assets and IRAs, to make contributions to qualified charitable organizations, such as ADF.
Example: Bill, a widower and loyal Ministry Friend, intends to make a generous gift (bequest) to ADF in his will. The bequest will be in the form of XYZ stock. He plans to leave the balance of his estate, including significant retirement plan accumulations, to his two adult children. Here is the likely tax impact (in 2008) of his current plan on his retirement plan assets:
Top federal estate tax bracket of his estate 45%
Top state death tax bracket of his estate 8%
Top federal income tax bracket of his heirs 35%
Top state income tax bracket of his heirs 4%
Less: federal income tax deduction for
federal estate tax paid on IRD –30%*
Effective rate of combined taxes 62%
*This will depend on how large the retirement plan assets are as a percentage of the estate. We have made an assumption here for illustration.
Under Bill’s current strategy, only 38 percent of his retirement plan assets will be left to his children — hardly what Bill was hoping to achieve after all those years of hard work, thrift and smart investment choices.
As an alternate strategy, Bill can designate the Alliance Defense Fund as a beneficiary or partial beneficiary of the retirement plan. The assets will not be subject to income taxes or death taxes to the extent they are used to satisfy the bequest to us. Additionally, the XYZ stock, if left to the children, will receive a “stepped-up basis” to its fair market value at Bill’s death, which may save capital gains taxes for the children should they later sell the stock. In brief, everyone comes out ahead!
Bill is like many of our Ministry Friends who want to make a lasting expression of their commitment to our mission. By funding his generous gift with retirement plan assets, he can realize his philanthropic dream at a far lower after-tax cost than might be possible otherwise, and still provide for his family.
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