It's true, were a large IRA to be abruptly cashed out in it entirety by your heirs after your death, this would likely precipitate a substantial income tax - a real catastrophe. Perhaps an even greater catastrophe might be the lost potential for growing all that wealth with the benefit of tax deferral for several additional decades and with only minimal required (and taxable) distributions.
Why would your heirs choose to cause a tax catastrophe? Perhaps because they are too young or simply too unsophisticated to know better. If you anticipate either possibility, there are preventive measures you may want to consider after checking with an expert.
Another reason heirs might cause an IRA taxation catastrophe is that they have no choice, they need the money. This problem may be more likely for an estate large enough to cause a substantial federal estate tax and which also consists largely of either IRA funds or both a sizable IRA and an illiquid asset such as an ongoing business. In some circumstances the combined Federal estate and income tax bills on an IRA may be in excess of 80% of its value. This is the tax time bomb referred to in various media.
Fortunately, good planning may address this combined estate and income tax problem. Details are beyond the scope of my comments here, but a strategy might involve the use of an irrevocable trust, gifting, a family limited partnership or limited liability company, life insurance, a business buy-out agreement and various other techniques and tools. The aid of multiple professionals may be required for this complex planning process.
Under current tax law, individuals with less than $1,500,000 may not need to worry about the double whammy of both estate and income taxes. However, as suggested above, even the less wealthy may want to take steps to assure proper beneficiary arrangements are made…enforced if necessary.
Sometimes, heirs are pressed by employer plan rules to take large amounts of money sooner and faster than they would prefer, and this may cause a tax catastrophe as well. For this reason, I generally suggest the contents of these plans be rolled over to IRAs. There are circumstances, though, when a rollover may not be wise. So, again, seeking guidance from a knowledgeable financial professional may be critical.
In summary, 401(k)s and IRAs may be effective tools for potential wealth accumulation. And even where there is a resulting so-called tax time bomb, there are strategies intended to defuse it. Investors with IRAs of any size, however small or large, may want to seek the aid of a properly qualified financial professional, not merely rely on a bank employee or broker in making important and possibly complex IRA decisions. There may be much at stake.
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