When a retiree dies and leaves his or her retirement plan to a spouse, there is no immediate tax consequence—in other words, no estate tax. The spouse pays ordinary income tax on distributions in the same way as before the death. However, when the surviving spouse dies, or if there was no spousal beneficiary, the IRS can collect twice.
Two types of tax
Two types of tax apply to retirement plan assets when the owner dies. First, the value of the account is included in the taxable estate of the deceased. Federal estate tax on the account can be as high as 45% of the plan balance in some years. Then the balance goes to the non-spousal beneficiary and is taxed again as ordinary income at the recipient's tax rate, which is often higher than the deceased's tax rate. Good deal for Uncle Sam. Not so good for the beneficiary.
With careful planning, the tax bite can be muzzled. The trick is to leave as little in the taxable estate as possible and pay the income tax using low tax rates.
Advantages of using an annuity
One way to minimize the amount left in the taxable estate is to use an annuity. An annuity is a contract with an insurance company that gives you a series of payments over time. The annuity can be structured to give payments over the joint life of the retiree and a beneficiary. This common type of arrangement is called a joint life and survivor benefit.
Using a joint life benefit minimizes the amount included in the decedent's taxable estate while guaranteeing payments for the survivor's life. Life insurance can be used in conjunction with this to cover the estate taxes due on the amount left in the estate.
This method also spreads the remainder payments over the life of the beneficiary who will pay tax on the distributions, but without the risk of a lump sum forcing an increase in tax bracket. Without using a lifetime distribution method, the non-spousal beneficiary would have to receive the balance of the proceeds and pay taxes in five years.
Annuity payout options
Annuities also offer other payout options:
With forethought and careful planning, you may avoid double taxation on your retirement plan benefit.
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