Taxes Incurred When Dying with an IRA

Qualified plans and IRAs are great ways to save for retirement. However, those accounts may suffer a heavy tax burden following your death. Assets in your retirement accounts are subject to ordinary income tax when they are withdrawn by your beneficiary. Also, the value of your retirement accounts will be included in your gross estate and may be subject to federal estate tax following your death, although your exclusion from the estate tax (for 2023, $12.92 million per person; $25.84 million per married couple) may offset this tax. (State taxes are not considered here.)

Accordingly, when planning for what your family will receive following your death, remember that any amount they receive from your retirement accounts will be reduced by income tax and possibly federal estate tax.

Strategies to Reduce Tax

There is more than one way to reduce the tax cost associated with passing a retirement account at death.

One of the ways to alleviate the otherwise full tax cost of transferring a retirement account to your family following your death, while transferring comparable or greater wealth to them, is to replace a portion of the highly taxed retirement account with the death benefit from a life insurance policy insuring your life.

Generally, unless certain exceptions apply, the death benefit from a life insurance policy is not subject to federal income tax, and if the policy is owned by someone other than the insured (such as an irrevocable life insurance trust) and the insured has no incidents of ownership in the policy, the death benefit is also not subject to federal estate tax.

How Does This Strategy Work?

This wealth replacement strategy uses funds distributed from your retirement plan to pay life insurance premiums. Upon your death, the life insurance death benefit replaces the amount of the retirement plan lost to taxes (or provides an even greater amount to your family).

Before undertaking this strategy consider the following:

  • Distributions from your retirement plan are subject to income tax. Be sure you can pay the tax from non-retirement plan assets as withdrawing assets from a retirement plan to pay income tax on a distribution, causes another income tax.
  • You do not want to do this if you have not attained age 59 1/2 as distributions before you attain that age are subject to a 10% penalty.
  • If you will need your entire IRA to maintain your lifestyle during retirement, then this strategy should not be used.
  • This strategy may not work when applied to your unique situation. The premium cost for a policy of life insurance is dependent upon many factors, including your age, your health and your family’s health histories, and your lifestyle (such as whether you use tobacco). Thus, the insurance company’s review of such factors may make the cost of life insurance unacceptable to you. In fact, your risk factors may be such that you cannot purchase life insurance at all.
  • You should prepare a financial plan illustrating the impact of any investment strategy on your financial situation. A PNC Private Bank®wealth strategist has the tools to help prepare these illustrations.

Should You Do This?

Each family’s financial position and planning goals are unique, and not every planning strategy is appropriate for each family.

Nevertheless, replacing “high tax” IRA assets with “low tax” insurance death benefits can be a good way to transfer greater wealth with less tax following your death.

Before engaging in any wealth transfer strategy, you should determine if it is right for you and your family. A PNC Private Bank wealth strategist can work with your legal and tax advisors to illustrate how such a strategy would apply in your individual circumstances.

If you would like to learn more about the strategy presented herein, please contact any member of your PNC Private Bank team.