When clients hear about my concentration in tax law, most of them offer a false belief that they don’t have enough assets to merit the services of a tax attorney. While it’s true that the tax law often favors the mega-wealthy, the Internal Revenue Code is full of nifty (and perfectly legal) techniques the everyday family can use to maximize wealth. Perhaps my favorite way for the common citizen to get ahead on both income taxes and even estate taxes is by optimizing retirement accounts.
Retirement accounts come in all shapes and sizes, but in general, they can be put into two broad categories: inherited retirement accounts (IRAs) and non-IRAs. The concept underlying both varieties is the same: the government gives you a tax benefit for self-funding your retirement. For “traditional” accounts, the tax law provides a deduction for all payments used to fund the account during a given taxable year. For “Roth” accounts, there is no immediate tax deduction for funding the account, but all distributions from the account after retirement age are free from income taxes. Contrary to popular belief, non-IRA accounts can be Roth accounts as well: for instance, a small minority of companies offer Roth 401(k) plans.
What’s more, the law also protects the balances in these accounts from almost every creditor you can imagine, except an ex-spouse in a divorce proceeding. This feature of retirement accounts can be a lifesaver for clients who are in professions that expose them to much greater personal liability than the average citizen: real estate development, medicine, pharmaceuticals, accounting, law, and the like.
The overwhelming majority of clients who consult me for tax and estate planning have substantial balances in their retirement accounts. Throughout my career, I’ve been disappointed to see how easily other practitioners can screw up the legal approach to these invaluable assets. If you and your lawyer can plan the right way, your retirement account can be the most powerful gift you can give your children, grandchildren, or other heirs.
To understand why, you should know a crucial difference between IRAs and non-IRAs. All IRAs get to use what’s known as the “stretch” feature, in which a beneficiary can take required minimum distributions (RMDs) over the beneficiary’s life expectancy. For non-IRAs, the entire account balance must be withdrawn by the fifth year after the original owner’s death whenever a non-spouse inherits the account. Between IRAs and non-IRAs, the differential in income tax outcome over the course of a beneficiary’s lifetime could be enormous; imagine withdrawing $500,000 from a traditional IRA (and paying the corresponding income taxes) over a five-year period, as opposed to withdrawing the same $500,000 over the actuarial life expectancy of a 21-year-old beneficiary. The latter situation could put the beneficiary ahead by tens of thousands of dollars in tax savings.
The benefits could be even stronger with a Roth account, for which the beneficiary wouldn’t owe income taxes ever again. From the original owner’s perspective, as long as her income tax rate and bracket stay roughly the same between the year of funding and the year of withdrawal, the character of the account doesn’t matter very much. But from a beneficiary’s perspective, Roth accounts are much more valuable than traditional accounts because the beneficiary will never owe income taxes on the account assets, regardless of how much income they generate or how much they appreciate while they’re still inside the Roth account.
For any client, the best possible outcome for her non-spouse heirs would be leaving them a Roth IRA inside of a trust. The heirs would enjoy the following benefits from that part of your legacy alone:
- Protection from all creditors, provided the trust is administered properly
- The ability to “self-direct” (choose your own) investments, provided the beneficiary is also a Co-Trustee of the trust
- Complete exclusion of the assets inherited and all subsequent income and appreciation in value, provided the assets stay inside the Roth IRA
- The RMDs are “stretched” over the beneficiary’s actuarial life expectancy, provided the trust is drafted properly
If you don’t have a Roth IRA right now, or even a traditional IRA, there’s no need to fret. After the turn of the century, most retirement accounts can be “rolled over” into a traditional or a Roth IRA through a technique known as the “backdoor conversion.” Your financial advisor should be able to counsel you about how to make this happen. If you convert from a traditional account to a Roth account, you’ll owe the corresponding income taxes on the account assets, but the conversion might be worth it anyway for two reasons. First, your new Roth IRA will be eligible for the benefits outlined above, which will make the conversion a home run for your estate plan. Second, if you pay the income tax bill using assets outside your retirement accounts, your portfolio will have the same after-tax value but better protection from creditors. If the income tax bill looks too cumbersome, see if you can roll over part of your account balance instead of the entire amount.
The beauty of leaving a Roth IRA in trust is the technique’s accessibility. Since almost every client consulting an estate planning attorney has a substantial retirement account balance, this simple yet extremely effective planning tool can benefit the middle class just as much as the wealthy elite.
Matthew E. Rappaport, Esq., LL.M.
(212) 453-9889
