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Why does an IRA need rescuing?

IRA rescue is an old term that has been around for years. “Rescuing” IRA assets means that you will be pro-active in reducing the overall taxes levied upon your IRA, 401(k), and 403b assets when you die.

What taxes am I talking about? Income and estate taxes. Most Americans strive, although they don’t always succeed, in deferring a portion of their annual income into IRAs or 401(k) retirement plans. Many would be better off not going out of their way to fund a qualified retirement plan due to the fact that funding a low expense, cash value life insurance policy can generate more after-tax income in retirement.

For now, let’s just assume that it is a good idea to defer money now in tax favorable plans or IRAs to grow wealth for retirement.

Because the money in IRAs and qualified retirement plans has been income-tax deferred, you will have to pay income taxes when you pull the money out at the income tax bracket you are in when the withdrawals happen.

Most people understand that and fund income-tax- deferred retirement plans anyway so they can take advantage of the tax-deferred growth, the theory being it’s better to have $1 growing tax-deferred than to pay 15-35 percent income taxes on your take-home pay, thereby leaving 65-85 cents on the dollar to invest in a tax-hostile environment.

What most people do not think about are the taxes due upon death should there be money left in an IRA or retirement plan. Will you have an estate tax problem?

President Obama and Congress are threatening to change the laws but as it stands today, the following chart shows you the estate tax exemption amounts depending on the year when you die.

Year, Estate Tax Exemption, Highest Rate

2009, $3.5 million, 45 percent

2010, N/A (taxes eliminated), 0 percent

2011, $1 million, 55 percent

Let’s assume all readers will die after 2011. What the above chart tells you is that you have a $1 million per spouse estate-tax exemption if you die after 2010. If you are not married and your estate is less than $1 million, you do not have to worry about estate taxes.

If you are married and your estate plan is set up properly, using living trusts to maximize your estate tax exemptions, your estate should pay no estate taxes if it is less than $2 million.

You also need to understand your estate is made up of all of your assets, which include IRA/qualified retirement money and life insurance proceeds not passed through an Irrevocable Life Insurance Trust.

If you have an estate-tax problem when you die and money in an IRA, qualified retirement plan, or an income tax-deferred annuity, that money can be taxed at between 75 and 85 percent.

I say can instead of will because if you were married that money will likely pass to your spouse.

The tax trap comes into play because not only does the IRS want estate taxes at your death, but also wants the income taxes due on your deferred money.

Remember, the reason you use an IRA, qualified retirement plan, or tax-deferred annuity is so you can build wealth in a tax-favorable manner due to the fact you can invest money into vehicles with pre-tax dollars and have tax-deferred growth (no dividend taxes or capital gains taxes are due annually in such accounts.

Therefore, when you die, your estate will be valued and if there is an estate tax problem and assets with deferred income taxes due, the IRS will collect both, and the taxes will, in fact, be between 75-85 percent of the value of such assets.

Larry Rubenstein, president of LER Financial Services LLC., can be reached at 907-8899.

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