The retirement plan concept leads us to believe that we should contribute as much as possible to IRAs and other tax-deferred retirement plans, and avoid withdrawing more than the required minimum distributions. While this strategy will maximize retirement plan growth and the likelihood that it will provide income late in life, it also sets up some retirees and their families for tax traps. We encourage retirees to discuss with their tax advisors and estate planning lawyers whether to pursue more aggressive retirement plan withdrawal strategy before the end of the year.
The minimum required distribution tax trap for retirees is mainly a lost opportunity to match deductible expenses with taxable income. If a retiree pays medical expenses without insurance reimbursement worth more than 7.5% of the retiree’s adjusted gross income, the retiree can deduct those medical expenses against taxable income. If the retiree’s income remaining after tax credits is less than the total value of potentially itemized deductions, the retiree is leaving tax-deductible expenses on the table and forfeiting an opportunity to take tax-free IRA distributions.
Even if a retiree has enough income to use all potential itemized deductions, the retiree may be able to save income taxes for future generations by taking extra IRA distributions and paying taxes on them. If a retiree’s children are employed in lucrative jobs, the children may be paying income taxes in higher income tax brackets than the retiree. In that case, if the retiree dies leaving a sizable IRA, the high income-earning children will have to pay income taxes on distributions from the IRA at their high income tax rates. A savvy retiree with high income-earning children will take larger IRA distributions than the required minimum distributions to pay taxes on those distributions at much lower income tax rates than the retiree’s children.
It is common for a married retiree to have a much larger retirement plan than the retiree’s spouse. In many cases, the retiree spouse may have very modest personal assets compared to the retiree’s retirement plan. Medicaid laws provide that the spouse of a nursing home resident can keep substantial assets (at least a vehicle, real estate, and more than $120,000 in Indiana) and still qualify the nursing home resident for Medicaid assistance to pay nursing home bills (more than $70,000 per year in Indiana in 2016). Unfortunately, if the nursing home resident is a retiree with a large IRA, the couple is stuck with either paying nursing home bills with the IRA, or cashing out the IRA to fund the nursing home resident’s spouse’s resource allowance and paying taxes in a high tax bracket. If the nursing home resident with the lopsided share of retirement assets had withdrawn from the IRA more aggressively in previous years, the spouse at home would not have had to face such a daunting choice of asset depletion on nursing home expenses versus asset depletion by taxation.
We recommend that retirees consult with their tax advisors and estate planning lawyers about retirement plan withdrawal strategies. Retirees should schedule year-end consultations with tax advisors every year, and schedule consultations with an estate planning lawyer at least every 5 years, or more frequently if changes occur in health, asset values, income, or multi-generation family dynamics. Couples with wealth below $1,000,000 and disproportionate retirement plan assets owned by one spouse should discuss long-term care planning with an estate planning lawyer with detailed knowledge of Medicaid resource, income, and transfer penalty issues concerning retirement plans and annuities.
Jeff R. Hawkins and Jennifer J. Hawkins are Trust & Estate Specialty Board Certified Indiana Trust & Estate Lawyers and active members of the Indiana State Bar Association and National Academy of Elder Law Attorneys. Both lawyers are admitted to practice law in Indiana, and Jeff Hawkins is admitted to practice law in Illinois. Jeff is also a registered civil mediator, a Fellow of the American College of Trust and Estate Counsel and the Indiana Bar Foundation; a member of the Illinois State Bar Association and the Indiana Association of Mediators; and he was the 2014-15 President of the Indiana State Bar Association.
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