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Author: edcosoft Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121061  
Subject: Re: DEATH OF AN I.R.A. HOLDER Date: 9/6/1999 9:37 AM
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edcosoft writes (in part):

So by the time they have taken it all out it will be taxed 55% AND 39.6%
for a net spendable of 5.4%


I reply:

It's not quite that bad. Assuming the heirs' marginal rate is in fact 39.6%,
that tax will only be paid on the 45% that's withdrawn, for a total tax of
55% + (39.6%)(45%) = 72.82%, for a net spendable portion of 27.18%.
--Bob


edcosoft replys:

Sorry, Bob, but when the heirs take the other 55% out to pay the 55% FET they will pay their 39.6% on that too. You only accounted for paying the taxes on what is left to them AFTER paying the FET. They could pay the FET out of the other assets, but when they withdraw the remainder of the IRA they will still pay their 39.6% on it.

55% + 39.6% = 94.6% to the IRS. And then another 7% to CA or NY and your heirs will wish they had never inherited the IRA. You MIGHT get a deduction (not a credit) for the CA tax and the FET but only if you itemize and the FET was actually paid to the Feds and not CA.

My suggestion to anyone well into the FET brackets is to cash in your big IRAs before you die (or at least before both you and your spouse die). Your heirs will THEN get .604 X .45 = 27.18% instead of 5.4%. That's $218,000 more cash to your heirs on a $1mil IRA.

If it's a 401k the "cash-in" is called a Lump Sum Distribution and it isn't at your tax bracket, but uses special tax schedules developed 30 some years ago to benefit retirees wanting to avoid this trap.

Where just cashing in the 401k or IRA for a net gain of 27% to your heirs is attractive, an LSD on a $1 mil pension or 401k could reduce the 39.6% to 23% to 30%, and even less on smaller pensions, for another $100,000 to $166,000 to your heirs. Actually, because this extra cash you get to keep because of the lower cash-in tax is ultimately taxed in your estate, your heirs only get to keep 45% of the $100,000 or $166,000, or $45,000 to $75,000. Most of us aren't that lucky, but there's a lot of 401k millionairs out there now.

The above examples assume the worst. A more likely situation is at a 31% tax bracket and 37% FET your heirs keep 32% of an IRA (35% if they can stay in the 28% tax bracket because they have other funds to pay the FET with). Since cashing it in might push YOU to the 39.6% bracket, your heirs only end up with 38%, or a gain of 3% to 6%. It might, however, make sense for you to cash out enough of your IRA each year to stay in the 28% or 31% bracket, pushing the gain to about 17%. Thats $50,000 extra after tax to your heirs on a $300,000 401k.

It is assumed that the funds after liberation will be invested in a tax avoidance fund such as Vanguard Tax Managed index 500 (G & I) and since there are other assets enough to trigger a FET the future growth on those funds will not have to be expended (and taxed), and will therefor get a step-up in basis at the retiree's death (and his spouse's subsequent death). Ed
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