Parents’ estate plan triggers IRA tax bill

Dear Liz: My sister and I are in the middle of distributing our parents’ estate. The beneficiary of the estate is a trust. Part of the estate consists of a traditional IRA, which will be split between my sister and me. The problem is that because the IRA will be distributed from the trust and is considered a non-spouse distribution, I’m told that we’ll have to pay taxes on the entire distribution. It’s a good chunk of change. I’m almost 60. Is there any way that I can roll the IRA into my own and take minimum distributions? I’d rather not pay the tax all upfront.

Answer: That’s understandable, since it’s typically much better to stretch distributions out as long as possible so that the money can continue to grow (and you can replace one big tax bill with smaller ones as you take distributions).

Unfortunately, the way your parents structured their estate ties your hands, although perhaps not to the extent you’ve been told.

It appears from your question that the IRA either failed to name a beneficiary or named the estate as the beneficiary, said Mark Luscombe, principal federal tax analyst for tax research firm CCH.

“Assuming that is the case, since estates do not have life expectancies, the IRA cannot be distributed over a beneficiary life expectancy as it could have been had an individual been named the IRA beneficiary,” Luscombe said. “Instead, it must be distributed under the terms of the IRA document over a period that cannot exceed five years.”

The exception is if the IRA owner before dying had already reached the age of 701/2 and begun distributions, Luscombe said. In that case, distributions can continue to the estate over the IRA owner’s life expectancy. If the IRA owner was quite elderly when he or she died, this might not give you much time to stretch out the distributions, but it probably would be better than paying all the taxes at once.

Another exception, which doesn’t appear to apply in your case, is if the IRA named the trust as the beneficiary. If that were true, “it is possible that the distributions could be based on the life expectancy of the oldest trust beneficiary,” Luscombe noted.

As you can see, this is a complicated area of estate planning and taxation. Getting good advice about how to name beneficiaries for your accounts can save your heirs a lot of money.

Get a second opinion before buying annuity

Dear Liz: Our advisor recommended that we convert our rollover IRA to an annuity. We are having difficulty researching this. Any suggestions?

Answer: Unless your advisor is a complete numskull, he probably didn’t mean you should cash out your IRA to invest in an annuity. That would incur a big, unnecessary tax bill.

The idea he’s trying to promote is to sell the investments within your IRA, which wouldn’t trigger taxes, and invest the proceeds in an annuity.

The devil is in the details — specifically, what type of annuity he’s suggesting. If he wants you to buy a variable deferred annuity, you should probably find another advisor or at least get a second opinion. The primary benefit of a variable annuity is tax deferral, which you’ve already got with your IRA. The insurance companies that provide variable annuities, which are basically mutual fund-type investments inside an insurance wrapper, tout other benefits, including locking in a certain payout. Those benefits come at the cost of higher expenses, which is why you want a neutral party — someone who doesn’t earn a commission on the sale — to review it.

If he’s suggesting you buy a fixed annuity, which typically provides you a payout for life, you still should get that second opinion. A fixed annuity creates a kind of pension for you, with checks that last as long as you do. There are downsides to consider, though. Typically, once you invest the money, you can’t get it back. Also, today’s low interest rates mean you’re not going to get as much money in those monthly checks as you would if rates were higher. Some financial planners suggest their clients put off investing in fixed annuities until that happens, or at least spread out their purchases over time in hopes of locking in more favorable rates.

You can hire a fee-only financial planner who works by the hour to review your options. You can get referrals to such planners from Garrett Planning Network, http://www.garrettplanningnetwork.com.

Young and broke? Open a Roth

You young’uns, listen up. Roth IRAs are the best thing since sliced bread. And the best time to contribute is when you’re young and broke, since you won’t always be that way.

Here’s the deal: contributions to a Roth don’t give you a tax break up front. But when you aren’t making much money, you aren’t paying much in taxes, so that’s an easy sacrifice to make.

The beauty of the Roth is when you take the money out. You can always withdraw your contributions without paying income taxes or penalty on the cash. But I recommend you don’t, because if you leave your Roth alone, those contributions—and all the lovely gains they’ll earn over the years—can be withdrawn entirely tax free.

Chances are, your tax rate will be higher in the future than it is now. The future you will be blessing the current you for tucking aside all that tax-free wealth. Every $1,000 you contribute in your 20s could grow to $20,000 or more by the time you’re ready to retire. If you’re so rich by then that you don’t need the money, you can pass the account on to your kids, and THEY can pull out money tax free.

That doesn’t mean you should ignore your workplace retirement plan—your 401(k) or 403(b)—especially if it has a match. But if you can possibly tuck some money away in a Roth, you probably should.

Starting one is easy—just about any bank, brokerage firm or mutual fund company under the sun will be happy to take your money. I like Vanguard’s target date retirement funds, since they do all the asset allocation and rebalancing for you, their expenses are dead cheap and you only have to have a $1,000 minimum investment to start a Roth there. (Don’t have $1,000 yet? Start a Roth at a credit union, save up and then transfer the account to Vanguard.)

Even if you aren’t so young anymore, the tax benefits of a Roth make sense if you’re likely to be in the same or higher tax bracket in retirement.

The ability to contribute to a Roth starts to phase out once your modified adjusted gross income exceeds $110,000 if you’re single and $173,000 if you’re married filing jointly.

Making money is a good thing. But I’ll admit to some sadness when hubby and I stopped being able to contribute to our Roths. These accounts really are a great deal.