Planning for tax-qualified plans, which includes IRAs, 401(k)s and qualified retirement plans, requires a careful examination of the potential taxes that impact these assets. Unlike most other assets that receive a “basis step up” to current fair market value upon the owner’s death, IRAs, 401(k)s and other qualified retirement plans do not step-up to the date-of-death value. Therefore, beneficiaries who receive these assets do so subject to income tax. If your estate is subject to estate tax, the value of these assets may be further reduced by the estate tax. And if you name grandchildren or younger generations as beneficiaries, these assets may additionally be reduced by the generation-skipping transfer tax. All told, these assets may be reduced by 70% or more.

There are several strategies available to help reduce the impact of these taxes:

  • Structure accounts to provide the longest-term payout possible.
  • Take the money out during lifetime and pay the income tax, then gift the remaining cash either outright or through an irrevocable life insurance trust.
  • Take the money out during lifetime and buy an immediate annuity to provide a guaranteed annual income, to pay the income tax, and to pay for insurance owned by a wealth replacement trust.
  • Name a Charitable Remainder Trust as beneficiary with a lifetime payout to the surviving spouse. The remaining assets would pass to charity at the second death.
  • Give the accounts to charity at death.

Structuring the accounts to provide the longest-term payout possible is the most simple and therefore the most common option. With this strategy you name beneficiaries in such a way that requires them to withdraw the least amount possible as required minimum distributions, or those distributions that must be made in order to avoid significant penalties. This can be accomplished by naming the beneficiaries individually or by directly naming their shares of a trust. Frequently, the surviving spouse is named as the primary beneficiary so that he or she may roll over the account into the surviving spouse’s name and treat it as his or her own account. Alternatively, if you are concerned the loss of creditor or divorce protection by naming the surviving spouse individually, you can name a trust for the survivor’s benefit.

Another option is to take the money out during lifetime and pay the income tax, then gift the remaining cash either outright via lifetime giving or through an irrevocable life insurance trust. If through an irrevocable life insurance trust, this strategy makes the most sense where you are in good health and able to obtain life insurance at reasonable rates. Unlike the IRA or retirement plan, the beneficiaries will receive the life insurance proceeds free of income and estate tax and, under certain circumstances, free of generation-skipping transfer tax.