WHAT IS A TRADITIONAL I.R.A.? Retirement Plan or Financial Time Bomb?

By now we have all become familiar with the term I.R.A. and should know it has something to do with planning for our retirement. But what exactly is an I.R.A. and should I have one?

The Traditional I.R.A. stands for Individual Retirement Account. These accounts were devised by the Federal Government as an incentive for people to save money for their retirement. While utilized by the general public, most NY probate lawyers and their clients alike are unaware of the dangers lurking within these Traditional I.R.A. accounts. Here is how they work.

A portion of your pre-taxable income during your lifetime is put into an I.R.A. account while the tax you owe on this money is deferred. Not tax deducted but deferred. It is important to note this distinction as a tax deduction reduces the overall amount of tax you owe while tax deferment merely delays the payment of the tax. This is supposed to encourage hard working Americans to save and invest their money while deferring their tax liability from interest, dividends and capital gains until they reach the retirement age of 70 ½.

Make no mistake, these distributions from your I.R.A. after 70 ½ are taxable events and are considered taxable income. As we all know taxable income is subjected to taxation at your respective level of income tax as determined by your tax bracket (traditionally between 35-42%). Unlike the Roth I.R.A., in a Traditional I.R.A. your taxes have not been paid on the funds deposited only deferred.

It sounds great doesn’t it? After all, who wouldn’t want to avoid paying income tax on taxable income today while earning tax deferred income until retirement? And it is this rationale that is creating huge problems for tomorrow’s beneficiaries of traditional I.R.A.s. While the I.R.A. sounds like a sound NY estate tool, the Traditional I.R.A. is actually creating a huge financial time bomb for your heirs after you pass.

The Traditional I.R.A. becomes a Toxic Estate Asset

After your death any and all funds in your Traditional I.R.A. are deemed part of your estate for estate tax liability purposes. As a NY probate lawyer practicing in Queens, I can tell you this tax liability is a disaster waiting to happen. Since the taxes on the funds in your Traditional I.R.A. have only been deferred, your heirs are eventually stuck paying your tax bill. Since the proceeds of the Traditional I.R.A. are taxed as income, that tax bill can easily exceed 40%. To make matters even worse the full amount, not the after tax amount, is the amount used to calculate estate tax liability. For example, A is a widower who wants to leave his entire estate to his only daughter. A dies owning a house with a market value of $700,000.00, a money market account containing$250,000.00 and a Traditional I.R.A. account with $200,000.00 at the time of his death. Keep in mind The NYS Estate Tax of 6% kicks in for all estates valued in excess of $1,000,000.00. While the Traditional I.R.A. in A‘s estate may be valued at $200,000.00 for estate tax purposes, the beneficiary will be lucky to see $120,000.00 after she pays the income tax owed on the amount. To make matters even worse, by using the full $200,000.00 amount in the Traditional I.R.A. to calculate estate tax liability, A‘s estate may now be subject to another $60,000.00 in estate tax liability. This is like pouring salt into an open wound. The result is A‘s daughter will eventually have to pay $80,000.00 in income taxes on the amount in the Traditional I.R.A. while A‘s estate may be subjected to another $60,000.00 in NYS estate tax on money that A‘s beneficiary will never realize. In probate terms, this is a nightmare.

There is a way to stretch out the beneficiary’s distributions with the Traditional I.R.A. over their lifetime. However the income derived from their distributions would still be subject to full income tax liability. Furthermore, this “stretch option” requires annual distributions to the beneficiary starting from the year of the account holder’s death. If one single distribution is missed, the beneficiaryMUST liquidate the entire account within 5 years of the account holder’s death, reporting the full amount as taxable income. These distributions are almost never taken in a timely manner as both clients and NY probate lawyers are unaware of these cryptic requirements.

Why is a Roth I.R.A. a better option?

As a NY probate lawyer I always encourage clients to opt for the Roth I.R.A. as opposed to the Traditional I.R.A. Here is why. In contrast to the Traditional I.R.A., a Roth I.R.A. is a savings account where the depositor puts money into the account after income taxes have been paid. Once deposited into the Roth I.R.A., any and all distributions from income generated within the account are tax-free. Since the funds are delivered to your beneficiaries tax-free, there are no hidden financial time bombs ticking for your beneficiaries to pay. Unlike the Traditional I.R.A. that inflates the value of your estate with funds that will have to be paid out in taxes, the Roth I.R.A. only values actual assets, the proceeds of which your beneficiaries will realize.

I have a Traditional I.R.A., what should I do?

Unfortunately, since most NY probate attorneys are unaware of these problems themselves, clients do not catch these hidden dangers before it is too late. Most of the time it is the heirs of clients who realize the inherent dangers of the Traditional I.R.A. when it is time to pay the tax bill. The good news is there are measures you can take today to prevent this hardship tomorrow.

Conversion: As a NY probate lawyer, I encourage my clients to convert their Traditional I.R.A. over to a Roth I.R.A. before they pass. This is the act of “rolling over” the account by paying the income taxes owed on the converted amount. By doing so, you are preventing a toxic asset from growing into a future hardship on your estate. With a Roth I.R.A., your beneficiaries are free to leave the money in the account to continue generating tax-free income or can liquidate the account at any time. Furthermore, since the income derived from the Roth I.R.A. is tax free, it will not drive your beneficiaries into a higher tax bracket when they choose to take distributions.

As a NY probate lawyer practicing in Queens, I can tell you the tax advantages of the Traditional I.R.A. are just not worth the cost. Although the idea of getting tax deferred revenue is enticing, these accounts are toxic estate assets. Honestly, who really wants tax deferred income these days from interest, dividends and capital gains anyway? Unless you own your own bank, chances are the interest you are earning on your savings accounts is not generating substantial tax liability. Additionally income derived from dividends and capital gains is taxed at a meager 15% for households earning $450,000.00 or less. Why defer paying 15% tax on dividends and capital gains today to subject yourself and your heirs to 35-42% income tax liability in the future? As you can see the only entity who wins here is the Government.

If you or a loved one is in need of NY probate or estate planning, call a NY estate lawyer at the Law Offices of Jason W. Stern & Associates at (718) 261-2444. As a responsible probate lawyer practicing in Queens, I often advise my clients not to leverage their family’s financial future by subjecting them to your tax liability derived from a Traditional I.R.A. account.

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