Last Updated Mar 9, 2010 10:41 AM EST
This idea probably won't save you any money in your 2009 taxes, but it's a very valuable tip for the long term. For any tax-advantaged accounts you have, such as IRAs, 401ks, and the like, it's essential that you name someone as beneficiary, so the account is passed on directly to someone. If you forget or put it off, whoever eventually inherits the funds could very well pay unnecessary taxes, and miss out on some important tax-free compounding. So check those beneficiary designations!
My father passed away last September at 85. While some men devoted spare hours in the basement to packing their own custom shotgun loads for duck hunting, or in the backyard working on their short game, and others were absorbed in Beverly Sills' arias of Puccini on hi-fi in the den, my father's avocation, his art form, was lowering his income taxes.
He spent Sunday mornings poring over personal finance magazines and newsletters in pursuit of the wily itemized deduction. His tax-fighting prime, during the 1960s and 1970s, coincided with a golden age of minimization, when The Code allowed the little guy to write off all sorts of stuff: credit card interest, sales taxes paid, and not only the cost of the orthodontist, but an allowance for the miles driven to get there.
He retired in the early 1980s, just before all the Reagan tax cuts took away the fun of filling out Schedule A, but he kept up with changing regulations and regularly grilled unsuspecting bank tellers. He called me one day in 2001, overjoyed to find out that if and when his heirs inherited the IRAs he had built up, they didn't have to cash in the account and lose a bunch to upfront taxes.
The idea behind this tax tip is as much estate planning as it managing taxes, but the amounts involved can be large. The beneficiaries don't have to cash it out all at once and pay lots of taxes: they can leave it invested, taking gradual withdrawals, and therefore have greater flexibility in their own saving and tax planning. (The rules are presented in IRS Publication 590 (2009), Individual Retirement Arrangements (IRAs).)
Assume these facts: Joseph K. dies at age 80, leaving an IRA worth $50,000. He has one heir, his son Fred, age 53.
Case 1: Joseph K. fails to name Fred as beneficiary. The IRA is included in Joseph K.'s estate. The estate can stretch out the distributions over Joseph K.'s expected lifespan, in this case 9.2 years, pay taxes on them and then pass them along to Fred. More likely, whoever is looking after the estate won't want to keep doing so for nine or 10 years, and will decide to pay the taxes upfront -- in this case at 25 percent -- to close the matter.
Fred starts out with $37,500 to invest, in an account that is now taxable. After 10 years invested at a return of five percent, after taxes at a marginal federal rate of 25 percent, the initial $50,000 IRA is worth a little over $54,000.
Case 2: Joseph K. names Fred as beneficiary. The IRA is not included in Joseph's estate, and goes directly to Fred. He can leave it invested as is, or move it to another bank, broker or fund company, and invest it however he wants. But he does have to start withdrawing over his own expected life span, which is 31.4 years. The minimum he has to withdraw in the first year is $50,000 divided by 31.4 years, or $1,592. (The next year his minimum is the account value divided by 30.4 years, and so forth, rather than going back to the life expectancy tables every year.)
Or Fred can take out more than the minimum, whenever he wishes. He pays income taxes on all distributions.
If Fred withdraws the minimum, and invests the distributions in a taxable account at five percent, but leaves the bulk of the account in the inherited IRA, invested tax-deferred also at five percent, in 10 years the two accounts are worth nearly $70,000. Even after distributions, the IRA is worth about $51,000, and the new account with the distributions has grown to about $18,000. (Better yet, if Fred set up a new IRA and invested the distributions tax free, the total would be a few thousand higher, and he might have gotten deductions from the contributions to his own IRA.)
It's just a matter of paperwork, but if you've someone you want to inherit your IRAs, be sure they're signed up. Just as important, see that they know the value of leaving the money untouched as long as possible. And you can change the beneficiaries at any time.
My friend Tom Zanecchia, a financial advisor of the highest order and head of Wealth Management Consultants in Denver, checked the soundness of my reasoning above, and adds this point:
If Joseph K. did not need the assets in the IRA, and wanted to pass it on to his children, then he probably ought to convert to a Roth IRA. He would pay the conversion taxes now from other funds, roll over the pretax amount into a Roth, and make his children the beneficiaries of that account. They would not have to take any distribution from the Roth until they need it, and get maximum tax-free buildup. The bottom line is comparing the present value of taxes paid on the built-up account in the future (with the Roth IRA, probably very little) to the taxes paid today.