Who wants to pay as much tax as possible?
I hope internally you answered "not me" very loudly. When it comes to income taxes we want to pay what we owe without leaving a tip. Tip your server, not the IRS.
Here is an example of a potential tax nightmare for the beneficiary of your IRA, 401k, or any retirement account where taxes have been deferred. That's essentially any retirement savings account that doesn't have the word Roth associated with it.
Let’s say you have a Traditional IRA or a Traditional 401k not in a Trust, worth $1 million dollars and you have named your only child as the beneficiary of that IRA. You are suddenly diagnosed with cancer and die within months of the diagnosis.
Your only son is married with a family and makes approximately $60,000 a year.
What happens to the money?
Your son was smart and called a financial advisor like us and we set up an inherited IRA for him where he could spread out the $1 million dollar inheritance over 10 years. He and his family get an additional $100,000 each year for the next ten years. This additional income changed their lives for the better and only increased their Federal Taxes by approximately $3,000 per year or $36,000 over the life of the 10 year inherited IRA. This is an ideal scenario and one you had probably hoped for.
Your son had no idea what to do and called the custodian of your IRA or 401k to ask for advice. They tell him they are sorry for his loss and ask him where they should send the $1 million dollar check? He gives them the address and excitedly deposits the check a week later. He’s never seen this much money before. He buys a boat, a new house, a new car and suddenly that $1 million dollars is gone. No big deal, right?
Wrong! By taking that $1 million dollar inheritance as a lump sum and depositing that money into his checking account it is taxed as ordinary income for that year. Instead of being taxed on $60,000 he will be taxed on $1,061,000 and his Federal Taxes for the year will be approximately $300,000!
He doesn't have the money to pay the taxes now because he spent it all. He has to sell his new house at a loss to pay his taxes. This is not an ideal scenario and instead of a blessing, your son inherited a curse.
What should you do?
All of this could have been avoided with proper financial planning and estate planning.
We all have to pay taxes. We have no control over that. However, we do have control on how we pay and often we have control over how much we pay.
Talk to a financial advisor about these decisions. Preferably one that specializes in retirement planning. Your kids will be thankful you did.
*This is not tax or legal advice.
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