A. What Happens When You Die

Not to get morbid or anything, but some folks die prematurely. Best to plan now (just in case) rather than later. A last will and testament delivered via Ouiji board will not be admissible in most courts of law.

In the event of your death, the assets in your 401(k) will be transferred into a traditional IRA.  If you had a Roth 401(k) it will be transferred into a Roth IRA.  Everything in this post that refers to an “IRA” also refers to a “401(k).”

B. The Beneficiary Form

The best and simplest way to transfer your IRA assets to your intended heir, is to name him/her/them on the IRA’s beneficiary form.  Keep it updated, and keep a copy.

Not only does the beneficiary form make it clear who gets the money, assets transferred through a beneficiary designation don’t go through probate– they are available immediately to the recipient.  If you don’t fill out the beneficiary form (and if you don’t have a will), your assets are transferred “by law” which usually means that the heirs will be your parents and/or siblings — perhaps not what you had in mind.

C.  Rich Straight People Really Are Different

When a federally-recognized spouse inherits an IRA, he/she can usually just roll the assets over into his/her own IRA account.  The assets grow tax-free until funds are withdrawn in retirement (or until the heir reaches the age of required minimum distributions, 70 1/2).

When a LGBT spouse inherits an IRA, the heir must begin paying taxes on it immediately.  Each year, the heir must transfer a certain percentage out of the IRA (a required minimum distribution, or RMD) and pay tax on it as income.  The percentage is based upon the heir’s age.  When young, the percentage is relatively small but rises as the heir ages.

Not only do LGBT folk miss out on the tax-free growth, but they have to pay the tax during what are presumably their highest-earning years.  This is contrary to the purpose of an IRA which is to defer taxes until retirement when the tax-bracket will (usually) be lower.

In addition a Roth IRA inherited by a spousal heir can be treated as the heir’s own, and the Roth grows tax-free and RMD-free.  A non-spousal heir must begin taking distributions immediately, albeit tax-free, losing all that good tax-free growth.

D. What’s the Financial Impact?

I created a spreadsheet to estimate the financial impact of this additional tax.  If you’d like a copy, please email me.

For the calculation, I assume the LGBT heir is in the 28% tax bracket and receives an average investment return of 4% above inflation.  Each year money is transferred from the IRA to a taxable portfolio at the heir’s RMD rate.  Tax is paid on the investment return of the portfolio and on the RMD’s.  I then calculated the value of the IRA and the value of the portfolio when the heir reaches 70 1/2.

For comparison, I also calculate what the IRA would be worth if it was transferred to a federally-recognized spouse.  It grows tax-free until the spousal heir reaches 70 1/2, at which time she/he also must begin making RMD’s.

Now I could inflate the difference by stopping there, but its not really fair to compare the LGBT heir’s portfolio + IRA to the spousal heir’s IRA, since the portfolio is post-tax, so I discounted the value of the IRA (at a tax rate of 28%).   The post-tax value of the LGBT heir’s retirement savings is lower than that of the spousal heir.  The percentage difference is shown in the chart below:

If your LGBT partner dies when you are 40 years old, you will lose about 10% more of the retirement funds that your partner left you to taxes than you would have if the federal government recognized your relationship.

The impact lessens if the event happens later in life, as there is less time for the IRA to grow.  By age 70 1/2, we all have to take RMD’s, but the disparity does not disappear, as spousal heirs have a lower RMD rate than LGBT heirs.  (Table I vs. Table III of IRS Pub 590).

I did not include the impact of an LGBT heir being taxed during  his/her high-earning years, so this estimate is conservative.

E.  Pension Protection Act of 2006

As bad as this might seem, it was much worse before the Pension Protection Act (PPA) of 2006.   LGBT heirs were not allowed to spread the distributions over their lifetime, but were required to distribute the value of the IRA over five years.  If the inherited sum was considerable, it could bump the heir into a higher tax bracket.  Some employers interpreted the PPA as optional, but the Worker, Retiree and Employer Recovery Act of 2008 made it mandatory.

F.  Strategies

One possible strategy to minimize the effect of this extra taxation is to designate your child as the IRA’s beneficiary.  Children also have to take RMD’s, but at their age, the RMD’s are small and the tax bracket typically low.  In addition, withdrawals for higher education are exempt from the 10% penalty, so you could use the inherited IRA to fund your child’s college education.  There are disadvantages to turning your money over to your children; talk it over with a financial professional if you’re considering this option.

Summary

If you’re a married gay person (or domestically partnered, civilly united, handsfasted, …), you’ll need to take some extra steps to make sure that your assets are distributed in accordance with your wishes.  There’s a financial penalty because the government does not recognize your relationship — both in the loss of the tax-free accrual of the IRA and the requirement to take RMD’s during your peak earning years (and hence higher tax-bracket).  Hopefully you and your loved ones will live a long and healthy life, and you’ll never be put into this situation, but forewarned is forearmed.

Reference: IRS Publication 590:  IRAs

Image credit: Kliefi at Flickr

Carnivals: This post was included in the 242nd Carnival of Personal Finance hosted this week at CashMoneyLife.