Unknown Tax Liability on Your Retirement Accounts

By J. Scott Fain

July, 2018

You’ve worked most of your life to accumulate assets in various forms, likely to some extent in Individual Retirement Accounts (IRA’s). The government has allowed you to defer income into these accounts and to delay paying taxes on them until a later date…the date the funds are withdrawn to fund your retirement or beginning at age 70½ when your required minimum distributions (RMDs) begin.

The upside is you have been able to use those tax dollars to generate growth for yourself and to defer the withdrawals and payment of taxes until you are potentially in a lower tax bracket. On the other hand, this creates some unknowns: what tax rates will be at the time of the withdrawals and what your tax bracket will be…so essentially there is an unknown tax liability on your account.

Some clients have substantial assets and may never need to access the funds other than as directed for RMDs. Other clients rely on these funds for retirement and often do not realize ahead of time the impact of having to withdraw not only the amount of funds they need for living expenses, but also the funds to pay the taxes on those withdrawals.

Further, clients often do not consider that the tax burden on their retirement accounts follows the accounts to the beneficiary and will be paid at the respective beneficiary’s tax bracket and rate.

What are some planning opportunities regarding these taxes on your retirement accounts?

Roth Conversions – Many times parents are in a lower tax bracket during retirement than that of their children.  Further, Georgia provides a Retirement Income Exclusion for taxpayers beginning at age 62, so Georgia retirees often do not pay state income taxes.  Parents with excess assets should consider Roth conversions to allow for payment of taxes now at their tax rates and to provide their children with Roth IRAs growing tax free.

Qualified Charitable Distributions (QCDs) – Many people write checks directly to charities, not knowing there are more efficient methods available.  One of these methods is through Qualified Charitable Distributions (QCDs).  QCDs allow you to make distributions from your IRA(s) directly to your charity of choice, never having to report the funds as taxable income to you.  In many cases, this provides a greater benefit to you than writing a check for a donation directly to the charity and then taking a deduction on your taxes.  By not counting the IRA distribution as income, you may reduce the amount of your Social Security benefits that are taxable, and you may reduce your Medicare premium, as both of these amounts are based on your amount of income.  As a bonus, QCDs count towards satisfying your Required Minimum Distributions (RMDs) which begin at age 70½.

You must have attained age 70½ to be eligible, and QCDs are limited to $100,000 per taxpayer, per year. The distributions can be done on demand or may be setup as recurring on a monthly or quarterly basis.  The distributions generally come in the form of a check made payable to the charity and are mailed to the client’s home address.  It is very important to coordinate with your advisor and your tax preparer to make sure these distributions are reported correctly.

Life Insurance – Another way to address taxes on retirement accounts is through life insurance.  Utilizing a permanent life insurance policy, such as Guaranteed Universal Life (GUL), on the individual or on a joint-life basis allows one to leverage a portion of his or her assets to provide a death benefit to pay the taxes on the account.  It is important to note that the death benefit comes in tax-free.  By utilizing a GUL policy, which is designed to provide the largest death benefit for the lowest premium, on a guaranteed basis, we can forecast the internal rate of return on the policy for a given date of death – i.e. the rate that you would have had to earn on the invested premium dollars to end with the amount of the death benefit on that date.  Assuming good health and insurability, these are generally favorable rates of return. (See also my article on Life Insurance as an Asset Class).  This option can be a good utilization of excess funds from RMDs as well.

Estate Planning – A simple, yet often overlooked, planning opportunity involves charitable bequests.  When selecting assets to leave to various individuals or charities, consider leaving your retirement accounts to charities and other assets to your children or other individuals.  Again, the tax burden on the retirement accounts follows them – whether to your children or to other beneficiaries.  Most other assets will receive a step-up in basis at your death to fair market value, thus they will have no tax burden.  Since non-profit 501(c)(3) organizations do not pay taxes, it is more efficient to leave them your IRAs and to leave your children your investment accounts, real estate, life insurance, etc.  Remember: Beneficiary designations supersede your Last Will & Testament.  Be sure to review your beneficiary designations on your IRAs, life insurance policies, and 401k accounts, and to review any Transfer on Death (TOD) designations, etc. in context of your desired estate plan.

Utilize the Roth Option – As an alternative to deferring taxes into retirement, the Roth IRA allows individuals to contribute funds into the Roth IRA account on an after-tax basis, meaning that you pay the taxes on the income now at your current tax bracket and rate and then defer use of the funds until retirement (after 59½ ).  Under this option, the funds grow tax free going forward until withdrawn.  If necessary, you can withdraw your contributions (not the growth) prior to age 59½ without penalty.  Many 401k plans now offer a Roth option for deferrals.

In summary, there are several planning opportunities that exist and should be considered regarding your retirement accounts and the unknown amount of taxes that will be due and payable by someone at some time.  Contact CapSouth for more information on these concepts and how they might apply to your particular situation.

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***This article is not intended as specific advice or recommendation. All decisions should be reviewed and considered in the context of your individual situation.  Please contact us for more information on how this information may be utilized under your circumstances.  CapSouth Partners, Inc., dba CapSouth Wealth Management, is an independent Registered Investment Advisor.  CapSouth does not provide tax or legal advice.  Please consult your tax or legal advisor before making decisions that may have tax or legal consequences.***