Unused retirement account money is a mixed blessing in estate

By James O. Preston, Senior Director of Advancement, University of Missouri

Editor's note
Revised June 2015

Retirement can be fulfilling and wonderful for well-prepared retirees. Tools available for individuals to build a comfortable retirement make it possible to create significant wealth over time. Most people are familiar with 403(b) and 401(k) qualified retirement accounts and individual retirement accounts, or IRA’s. These instruments are revolutionizing the way that American’s prepare for their post-working years.

While qualified retirement accounts are excellent for building wealth, they can pose a tax liability when distributions are received. The wealth a retiree has accumulated before taxes during work years may push him or her into a higher tax bracket in retirement when fewer deductions may be available. In death, the tax treatment of these accounts when passing to heirs can be a mixed blessing.

Retirement accounts of a deceased individual fall into a category of income that the deceased individual was entitled to at the time of his or her death. Such income is referred to as income "in respect of a decedent" (IRD). The final income tax return only reports income received during the lifetime of the decedent. In most instances, children or other heirs who are beneficiaries of a retirement account will be responsible for the income taxes. The size of such accounts and the amount of the potential tax make such bequests a concern, potentially eroding the value of the inheritance. Taking action now and planning for the future will help preserve your wealth and preserve your legacy to family and to charity.

Pay now and give later

Converting a Traditional IRA to a Roth IRA will create a tax-free source of retirement income and can provide a great strategy to reduce the potential IRD in your estate. The conversion will require you pay income tax now so consult a tax adviser to determine the best way to do this. Having already paid the taxes in a Roth account makes it a better asset to pass to heirs as well since it will not carry IRD.

Another option is to spend down existing retirement accounts incrementally, spreading out the tax burden over a number of years so that the size of the accounts are reduced or used during your lifetime. Some people will use part of the income after taxes from their retirement account to create a life insurance policy to help preserve the value of their heirs’ inheritance.

Perhaps the most straightforward method to reduce the tax liability of IRD is to designate a charity as a direct beneficiary of an IRA or other retirement account. By having such a beneficiary designation, the estate avoids all income taxes associated with IRD and also receives a charitable deduction.

Charitable IRA rollover does NOT roll over to 2015

Another year and the situation looks the same as last, leaving us to wonder: Will Congress reactivate the charitable IRA rollover law in 2015? The charitable IRA rollover has been popular with tax payers who are required to make a minimum distribution (RMD) from their retirement accounts to meet the requirement through a rollover to a qualified charity from their IRA.

Passed mid-December of last year, and only for 2014, donors who moved fast or acted earlier in the year anticipating Congress’s action were able to take advantage of the law. A push to make the charitable rollover permanent is already afoot in 2015 but Congress may or may not extend the provision to this year.

In past years, the IRA charitable rollover law was in force, and certain rules remained constant:

  • You must be age 70½ or older at the time of the gift.
  • You may transfer up to $100,000 directly from your IRA.
  • This opportunity applies only to IRAs and not to other types of retirement plans such as 401(k) or 403(b) accounts.
  • You must transfer the funds directly to a qualified charity. The legislation has not allowed direct transfers to charitable trusts, donor advised funds, charitable gift annuities or supporting organizations.

Consult your legal and tax advisers for assistance with any gifts from your retirement accounts. Tax law governing gifts from retirement accounts change from time-to-time. The information in this article is intended for educational purposes only.

We can help. Our gift planners can provide you with additional educational information to take to your advisers as you are creating your plan that would include a gift to MU.

Call us at 800-970-9977; or email us at giftplanning@missouri.edu. You can find further information on these and other gift and estate planning topics at our website www.bequest.missouri.edu.