What is an IRA ?
An Individual Retirement Account (IRA) is an account into which you place money to protect it from taxes. You may contribute no more than $3,000 per year. People 50 and older may contribute an additional $500 per year, for a total contribution of $3,500.
You may not make further contributions once you turn 70˝ years old. You may begin making withdrawals from your IRA at age 59˝ without penalty. In the year after you turn 70˝, you are forced to withdraw assets from your IRA so that you do not own any assets at the end of your life expectancy.
You begin an IRA account by completing certain forms at a bank, savings and loan, mutual fund or insurance company. You will make annual deposits into the IRA, and formal records will be kept to keep track of your money. The contributions must be made in cash by April 15 of the next year. These contributions are not taxed at the time you put them into your IRA, but they will be taxed when you take the money out of the IRA account, or when the money is given to beneficiaries after your death.
Taxation of IRAs
All of he money in your IRA account will be taxed in your Estate when you die. The Federal Government taxes your money twice, once when you earn it and once when others inherit it. If you put assets in an IRA, you pay no income tax when you earn them. Income tax is due when you withdraw those assets or when they are distributed at your death. Therefore, you may have to pay federal Estate taxes and federal income taxes on the assets in your IRA accounts.
Federal income taxes will always be owed on your income, including income that you deposit in an IRA account, but you will not be responsible for the taxes on the income put in an IRA account until it is withdrawn or distributed. The taxes are deferred, but not eliminated.
When you die, there are different people that may receive the money that has been held in your IRA account. Either your spouse, someone other than your spouse, or your Estate may receive the money. When money is inherited by someone other than your spouse, the government charges estate taxes. The government determines how much they can tax you by figuring out what makes up your gross Estate. A gross Estate is the property that you own, or had an interest in, during your life. This will include such items as your insurance policies, your home, your car, your bank accounts, your stocks and your IRA accounts, to name a few. It does not include assets inherited by your spouse at your death.
Federal Estate taxes are only owed when the portion of your gross estate not inherited by your spouse is worth more than $1.5 million. This amount is set to gradually increase to an unlimited amount in 2010. After 2010 we do not know what the amount will be. If you do not have property or valuables that is worth more than this $1.5 million you may not have to pay Federal Estate taxes. Money inherited by a spouse is also exempt from Federal Estate Taxes.
When Your Spouse is Your IRA Beneficiary
When you die you will have the option of transferring all of your assets to your spouse. When you pass your assets to your spouse, the transferred assets are not subject to Federal Estate Tax, but will be taxed once your spouse dies. By waiting for your spouse's Estate to pay all of the estate taxes on the assets, you may actually pay more in Estate taxes, because you have lost the benefit of using the $1.5 million exemption, and because tax rates rise as Estates get larger.
One way to make sure you use the $1.5 million credit is to put some of your IRA proceeds into a trust created by your will. The trust puts the IRA assets in the name of your children, but entitles your spouse to receive income from the money in the trust. The $1.5 million credit is applied against the assets in the trust since the assets are in your children's names. Therefore, your spouse receives money for the rest of his life and the assets are not added to your spouse's Estate and taxed at a higher rate when your spouse dies.
If you name your spouse as your IRA beneficiary, you will pay no estate tax on that transfer since any transfer to a spouse is exempt from estate tax.
Your spouse, however, will be responsible for the income taxes that come from the IRA account. However, a surviving spouse can defer those taxes. Your spouse may rollover the money received from your IRA into their own IRA within 60 days. Your spouse will be assuming the IRA money as if it were their own. It is important to note, however, that income taxes will still be paid on the IRA proceeds, but they are further deferred.
Distribution of IRA proceeds to your surviving spouse must occur by the later of two dates. Payments from the IRA account must begin by either December 31 of the year following your death, or by December 31 of the year you would have turned 70˝. The surviving spouse does not have to receive all of your IRA assets within 5 years, as is described below.
When Your IRA Goes To Your Estate
As is mentioned above, a trust created in your will, or your estate itself may be your IRA beneficiary. The person who is responsible for handling the Estate is referred to as the Executor or Administrator. The person in charge of administering a trust is a Trustee. The trust created in your will and your estate are two separate legal entities. The Executor administers your estate and pays Federal Estate Taxes and, when done, distributes to the beneficiaries, which could include a trust. Taxes will be owed only when your assets are greater than $1.5 million. The Executor will also have to pay income taxes on any IRA proceeds that the Estate has received. The rate is determined by the Estate's current income tax bracket. Once the income taxes are computed, they are paid by the Executor.
An Example
A general example may help bring some of these points together. Suppose that you have $2.7 million in IRA assets. You have named your spouse as the beneficiary of the entire $2.7 million in IRA assets. Since these assets go to your spouse, your spouse pays no Estate tax. Your spouse may then roll the money into a new IRA, and they do not pay any income taxes on the $2.7 million.
Once your spouse dies, however, no Estate or income taxes have been paid on the $2.7 million from your Estate. Your spouse may subtract the $1.5 million credit, leaving the remaining $1.2 million subject to Estate taxes of approximately $427,800. The beneficiaries of your spouse's IRA also pay income tax on all the IRA assets.
If you had put $1.5 million from one IRA into a trust that pays income to your spouse but leaves the money to a separate beneficiary, such as your children, your Estate will use the full $1.5 million credit at your death and those assets would not be taxed at your spouse’s death, but the trust would pay income taxes on the IRA proceeds.
Estate tax due on the $1.2 million in IRA assets that went to your spouse will be offset by your spouse's $1.5 million credit. The remaining $200,000 will be subject to only about $54,800 in Estate tax at your spouse's death, saving approximately $373,000 in Estate taxes. Your spouse would rollover the remaining $1.2 million into her own IRA and the IRA assets would be taxed as she withdrew them. The more money you protect by using the $1.5 million credit, the lower your tax due, leaving more for the people you want to have benefit from your assets.
Other Types of IRAs
Roth IRA: A Roth IRA is a type of IRA account that does not defer income taxes on assets placed in it.
- When are assets in a Roth IRA taxed?
The assets are taxed when they are placed in the IRA, at normal income tax rates.
- Are there any limitations on Roth IRAs?
Roth IRAs are available only to taxpayers who have adjusted gross incomes below $110,000 for single taxpayers, and $160,000 for married taxpayers filing jointly.
- How are assets in a Roth IRA taxed when they are distributed?
As long as the Roth IRA is at least 5 years old and the IRA participant is at least 59˝ or the distribution occurs because of his death or disability, they are not subject to income tax. There is also a special first-time home buyer exception, where the IRA distribution may incur no income taxes.
Education IRA (Coverdell Education Savings Account): An Education IRA, known as a Coverdell Education Savings Account, may be used exclusively to pay for higher education costs of you children.
- When are assets in an Education IRA taxed?
The assets and earnings in a Coverdell Account are not taxed when deposited or withdrawn, but they are also not deductible for income tax purposes.
- Are there any limitations on Education IRAs?
Contributions to Education IRAs are limited to $2,000 per child, per year. These contributions are in addition to, not in place of, the $3,000 limit for individual IRAs.
Other limitations do apply, such as limits on qualification for Hope Scholarships of Lifetime Learning credit. Consult your financial advisor for further information.
Education IRAs are different from 529 Plans, also known as prepaid tuition plans and college savings plans, which vary by state. Those plans are discussed in the Education Planning Newsletter.
