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Offsetting the Tax Ramifications of Required Minimum Distributions For Inherited IRAs

Posted November 14th, 2011 in Investing, Taxes by Jeremy Waller

Roth IRA and Taxes

This following is a guest post from John Papa, president of Diversified Planning Strategies. More information about John can be found at the bottom of this post.

Those looking to pass on their hard earned wealth by way of an IRA often fail to account for the potential tax ramifications of required minimum distributions for inherited IRAs. Even someone that does not need these distributions to live is required by law to start taking them at age 70.5.  If they don’t, Uncle Sam can become an unintended heir.

By marrying a few financial tools though, portfolios can avoid being sabotaged by the IRS and offset the tax implications of these distributions.

How is this possible? Well it starts by taking on a mortgage. Since many retirees have spent the better part of their lives working to be mortgage free, this might seem rather unconventional; however, by combining a mortgage with guaranteed investment vehicles, investors can significantly reduce the taxes due on required minimum distributions and provide their families with guaranteed money.

The process is best explained by way of example

Joe is a 65-year-old aspiring retiree who has $500,000 in an IRA that he intends to gift to his children as he will not need to live off of it.  Even still, Joe will have to start taking required minimum distributions at age 70.5 and by then, assuming a 6 percent rate of return, his IRA will be up to $669,113. If Joe lives to 90, continuing with the 6 percent returns, his IRA balance will reach $736,756 and his total required minimum distributions over that time will be a $908,005. Between the two, that’s $1,624,338 in total taxable distributions!

However, Joe and his family can avoid paying taxes on the full $1.6 million by taking on a mortgage on Joe’s already-paid-off $700,000 house. If Joe takes on a $500,000 mortgage with interest only payments for 30 years, the interest on the mortgage will be 100 percent tax deductible. If Joe takes $25,000 a year out in required distributions, but pays $25,000 in interest on his mortgage, those two offset.

Also, when Joe refinanced his house, he received a $500,000 check from the bank. While it would not be wise to invest that money in an uncertain stock market, he can put those funds in a guaranteed product like an indexed annuity with an income rider. That indexed annuity will give Joe a guaranteed payout of $29,000 a year, with which he can buy a guaranteed death benefit life insurance policy which will pay $1.1 million tax free at the time of his passing.

That $1.1 million can be used by his family to pay off the remainder of the mortgage if they wish and only $500,000 of a potential $1,624,338 is now taxable.

By marrying a few different financial products through a somewhat untraditional strategy, Joe can greatly reduce the impact of a taxable event and leave that much more to his heirs while eliminating the uncertainties of the markets.

John Papa is the president of Diversified Planning Strategies, with over 25 years of experience in financial services. He specializes in helping current and aspiring retirees generate and protect their assets. His expertise has been featured on various news outlets, including DailyFinance, Reuters and FOX News.com LIVE.

Your Turn

What do you think of this strategy? If you had a relative in this situation, what would you do to minimize taxes?

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8 Responses so far.

  1. When it’s about inheriting someone else’s money chances are that this will be a surplus. Why not paying tax upfront by converting in to Roth and be worry free.

  2. Jackie says:

    I had the same thought as SB. Also maybe I’m not understanding something, but wouldn’t this strategy mean that you pay $625,000 in order to avoid being taxed? Surely the taxes would be less than that, unless you have an enormous income in retirement anyway?

  3. I don’t think it is wise to take out an IO mortgage. While rates are low now, they won’t be in 5-10 years.

  4. Plus, what happens if the annuity company goes out-of-business? You’d lose your money then.

  5. Interesting strategy. Seems complicated.

    In regards to his personal residnce, I would probably use a QPRT to avoid gift tax at his and pass his personal residence that way.

    With the IRA, assuming that this his tax bracket is 40% then a $25,000 distribution would equate to $10,000 in taxes.

    By refinacing the paid off property, he’s paying the banks $25,000 per year to save $10,000 in taxes. Seems like theres a better way to do this. I’m not a tax or financial planning expert, but maybe he could roll his this IRA into a self directed IRA that allows him to purchase real estate. Buy a $500,000 duplex property and use the depreciation to offset the taxable distributions. Just a thought.

  6. Jeremy says:

    I am purposely not responding to comments here because I don’t feel qualified to offer tax advice at this level. Though, I think everyone above offers some great view points.

  7. Evan says:

    Why an indexed annuity? just so you could fit in those keywords? Why not a SPIA? Plus that type of strategy only works if you have a super healthy 65 year old since the annuity isn’t rated and the life insurance is.

  8. Charles says:

    wow that sounds like a great strategy. If i’m in that kind of position when I retire, then i’ll be happy.

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