TAXTEMBER: The IRS: Your Forgotten Beneficiary

TAXTEMBER: The IRS: Your Forgotten Beneficiary

September 11, 2023

TAXTEMBER is upon us.  A month of weekly tax education about how to be smarter when it comes to tax savings

 The moment you start contributing to a 401(k) or IRA account, you have entered into a contract with the "tax man". 

When I meet with clients to discuss beneficiaries on their IRA accounts, they typically discuss wanting to leaving their money to their children. For example, if a couple has an IRA worth $1,200,000 and three kids, they will typically give each child $400,000 when they die.  I unfortunately have to remind them that there is another “beneficiary” out there and they will make sure they get their share of the money also.  Taking this beneficiary into account, the benefit to their children may be closer to $300,000, instead of $400,000.

Who is that forgotten beneficiary? Yep, you’re right…it’s the IRS.

Why Does the IRS Get a Share?!

When we are start contributing to a 401(k) or IRA we enter into an arrangement with the IRS.  We say…I don’t want to be taxed now, so I will pay my tax at a later date.  Clients tend to forget that.  

In the example above, the $1,200,000 IRA is really worth closer to $900,000 to the client in cash and $300,000 will go to taxes.  Those taxes are incurred when the client does a distribution from the IRA after the age of 59 ½, or if they wait until age 73, they are required to start taking distributions in the form of an RMD (Required Minimum Distribution). So, no matter when you start to take those distributions, the IRS wants their share of the taxes that you have deferred until now. 

What About an Inherited IRA?

The same process will take place when the client dies and his/her children inherit the IRA.  A portion of the money will go to their child’s checking account, but first they will have to pay the IRS their share.  Those rules have recently changed so discuss that situation with your financial advisor. 

So, when planning ahead on your retirement accounts always remember...the IRS is the beneficiary that will always be there ready to take a portion of your IRA accounts.

 What Can I Do to Minimize the IRS’ Share? 

While you most likely won’t be able to escape totally tax-free, there are several strategies that can be implemented to reduce the portion due to the IRS.  This includes:

  • ROTH Conversions - By converting traditional IRA funds into a Roth IRA, you pay taxes on the converted amount upfront, but future qualified distributions will be tax-free. This strategy can reduce the overall tax burden on your beneficiaries.
  • Naming Charitable Organizations as Beneficiary of the IRA - Consider leaving a portion of your IRA assets to a charitable organization. This approach allows you to support causes you care about while potentially reducing your taxable estate.
  • Qualified Charitable Distributions (QCD) – Doing a distribution from your IRA to a charitable organization is tax-free.
  • Planning Your Distributions – May help reduce your payment to the IRS if you have a several year plan to take distributions and taking advantage of various tax brackets.

By taking proactive steps, you can maximize the amount of money your loved ones will receive and minimize how much the IRS will get from you.

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If you would like to receive an analysis of your 1040 Tax Return to discuss any of the Taxtember strategies contact our office.