Self Directed IRAs and Your Taxable Estate
Self Directed IRA, self-directed 401(k) accounts, SEPs and SIMPLE plans are normally part of your estate.
That means that upon your death (or the death of your surviving spouse, if any), any amounts in your estate, including your Self Directed IRA assets, will be subject to the federal estate tax.
Effectively, your estate will likely have to pay about 40 percent of anything it owns in excess of $5.43 million, as of 2016. The latter amount is adjusted upward annually for inflation.
If you have assets worth more than this amount, then, and they aren’t necessarily highly liquid (that is, easy to sell quickly without having to discount heavily), then you may need to do some planning to ensure that your heirs will have access to enough cash to pay the estate tax within six months of your death.
This can be a problem for some Self Directed IRA owners. Real estate, in particular, can be illiquid and tough to sell in time to raise the necessary cash. The same is true if you have significant investments in other asset classes that are popular with Self Directed IRA investors:
- Tax liens and tax certificates
- Private lending
- Hard money lending
- Precious metals
- Commercial lending
- House flipping
- Closely held corporations
- Farms and ranches
Each of these can be very lucrative investments for skilled Self Directed IRA owners. But the can also be very illiquid. If all your available cash is lent out on long-term mortgages, for example, it can be tough to raise significant amounts of cash in the short-term to pay the estate taxes without having to have a fire sale and unload assets at bargain basement prices.
This is why many of our more successful Self Directed IRA-owning clients make use of estate planning strategies to maximize the legacy they are able to pass on to their loved ones, and minimize the burden on their families.
If you believe your estate will exceed the estate tax exemption threshold when you pass away, however, there are some things you can do to preserve your financial legacy and maximize the amount you leave to your heirs. Here are some of the more common strategies.
Many people choose to convert large amounts from traditional IRAs to Roth IRAs. You can do the same strategy with assets in 401(k) plans, as well. When you convert, you must pay income taxes on the amount converted. However, anything you pay out in income taxes is money that won’t be eventually subjected to the effective estate tax rate of 40 percent, which is higher than any income tax bracket, even for very high earners.
This strategy works best if you can use assets from outside of your IRAs to pay the income taxes.
Roth IRAs and 401(k) Plans
By the same token, taking the income tax hit up front and choosing to make contributions to a Roth IRA or Roth 401(k) plan can also move assets out of your taxable estate and lower your eventual overall estate tax rate. Assets in these accounts grow tax-free, and income from them in retirement is tax free.
Second-to-die life insurance
These life insurance policies pay a tax free cash death benefit on the death of the second spouse – right when the estate tax bill will become imminent. They are therefore ideal tools for estate tax planning. Many people use irrevocable life insurance trusts, which moves the life insurance policy itself out of the taxable estate. Otherwise the life insurance would become subject to the estate tax all by itself.
Simply giving away some of your wealth to loved ones can be a tremendously effective and personally rewarding estate tax strategy as well. As of 2016, there is a $14,000 gift tax exclusion in effect per person per year. That means a married couple can give as much as $28,000 to each child, for example, without tax consequence.
You can give higher amounts, as well, with no immediate tax consequence. You just report the gift and any amounts over the exemption are counted against the lifetime exemption to the income tax.
You can’t ‘give’ away assets in your self directed IRAs without generating possible taxes and penalties – it will count as a distribution, unless you make the withdrawal for a qualified hardship exemption. But you can execute this strategy with other assets and it still works just as well as an estate tax mitigation technique.
American IRA is a leading authority on the administration of Self Directed IRAs. With offices in Charlotte and Asheville, North Carolina, we work with successful investors all over the country. Contact us today at 866-7500-IRA(472), or visit us online at www.americanira.com and peruse our extensive library of informational blog posts, articles and e-books.