Ask the Taxman by Andy Biebl

DTN Tax Columnist Andy Biebl is a CPA and tax partner with the accounting firm of CliftonLarsonAllen LLP in New Ulm and Minneapolis, Minn., a former president of the Minnesota Society of CPAs and a national authority on agricultural taxation. He writes for both DTN and our sister publication, The Progressive Farmer. To pose questions for upcoming columns, email AskAndy@dtn.com.

Question:

I inherited an annuity my mother purchased inside of an IRA. All of the proceeds are 100% taxable. Is it better to own annuities outside an IRA, so proceeds are tax-free just like life insurance?

Answer:

An inherited traditional IRA (but not a Roth IRA) always produces taxable income, regardless of the investment that was inside the IRA. The funding into the IRA was tax deductible, and so the distributions, whether to the retiree or the heirs, represents taxable income. Your only choice on an inherited IRA is whether you take that income in a few years after the inheritance, or stretch it out in smaller increments in a life expectancy withdrawal.

As to the taxation of an annuity outside of an IRA, there is a misconception in your question. One of the features of an annuity is that the inside investments grow in a tax-deferred manner. Whether the annuity holds interest-bearing or mutual fund accounts, the earnings and capital gains are not taxed until distributions occur. But those interests, dividends, and gains are ultimately always taxed, whether to the original investor or the heirs.

Annuities are complicated products and contain an insurance feature that is part of their internal costs. Generally, the contract will provide some guarantee of principal, as well as a minimum earnings feature, if it is not a pure variable contract. Another feature is the ability to annuitize and take the payout over lifetime; this shifts the risk of longevity to the insurance company.

Having seen numerous annuity investments with clients over many years, my sense is the tax deferral aspect is oversold by insurance companies and the risk shifting annuitization feature is underutilized by investors. Also, with regard to annuities inside an IRA, it generally makes little sense. The tax deferral feature is wasted and the annuitization is impractical, yet the overhead for those features is built into the investment.

Question:

Should a retiree with a small, simple estate use Transfer-on-Death forms of ownership for mutual funds, stock, and bank accounts in order to keep property out of probate? I received an inheritance from an Iowa estate and the attorney says this would have saved the 2% commission he can charge on accounts without it.

Answer:

The probate process will vary somewhat from state-to-state. But in general, probate is a process that applies to a decedent's assets that are directed to their heirs via a will. If the assets are transferred via a revocable living trust that becomes irrevocable at death, or if they are transferred by a form of ownership, they are not part of the probate estate that is governed by the will. Placing title to accounts in joint tenancy with an heir, or adding a Transfer-on-Death secondary owner, or by designating a beneficiary for an IRA, qualified retirement plan, or annuity are all ways to sidestep the probate inventory.

The probate process is designed to assure that a decedent's assets are actually transferred according to the directions within their will. The executor or personal representative for the estate must prepare a probate inventory that identifies all of the assets and liabilities, and then demonstrate to a probate court official that those assets were actually disbursed to the proper heirs. This is a form of protection that some will find valuable. And putting all assets into a title arrangement that sidesteps probate can leave the personal representative without any assets to pay the estate liabilities.

Unfortunately, in a small number of states, such as Iowa, there is still an antiquated fee system that allows attorneys to charge optionally based on the size of the probate estate. Most states have reformed their probate system, and attorneys who assist in the transfer of title may only charge normal hourly rates.

Question:

My 83-year-old mother has a sizable sum in IRAs. I understand as heirs we owe income taxes when we inherit that account. Are there ways to manage this tax obligation during her lifetime assuming that she is at no risk of running out of money for her healthcare needs?

Answer:

Your question raises an important distinction as to the assets owned by retirees: they are either pre-tax or post-tax investments. IRAs (other than Roth accounts), qualified retirement plans, pension amounts, and annuities all bring taxable income when withdrawn. But other investments, such as bank savings, mutual funds, stock investments, funded with after-tax dollars, generally have little income or taxation when withdrawn, other than perhaps some capital gain taxed at lower rates. So, in simple terms, retirees tend to have assets in two piles: one that brings taxable ordinary income (e.g. your mother's IRA) and the other accounts that do not.

But the tax rules tend to cloud how we deal with those assets in retirement. The Minimum Required Distribution or MRD rules that govern IRAs and other qualified retirement plans force a retiree, starting at age 70 1/2, to take minimum annual withdrawals. So most tend to plug into that system, take the minimum, and effectively do little to deplete that large IRA. The MRD rules promulgated by the IRS take a very conservative approach, and start at age 70 1/2 with only about a 3.4% annual withdrawal rate. At age 80, the minimum withdrawal is only about 5% of the account. Translation: most retirees won't seriously deplete those IRAs, if they use the MRD schedule, unless they achieve an extended life expectancy. The result is that these tax-deferred accounts are passed on to children who inherit them in their peak earning years, and pay significant income taxes.

One solution is for those children to recognize their ability to take their respective share of the IRA, and stretch it out in a further deferred payout over the child's life expectancy. That will spread out the taxes, but more importantly continue the growth of the account in a pre-tax manner before all of the payouts occur.

Another option, while mom is still alive, is to more carefully manage the withdrawals. When medical costs and extended care expenses arise, which generally are tax deductible as medical deductions, consider cranking up those IRA withdrawals to have offsetting income. But even without that, how many retirees are under-utilizing IRA withdrawals and wasting their itemized deductions and personal exemptions, and instead deferring the account to drop onto their high income children?

(MZT/CZ)

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