(Article from Kiplinger Magazine, March 1996, by Ronaleen Roha)

If your assets are substantial, poor planning could cost beneficiaries up to 90% of what's left. If assets are modest, the consequences may be only slightly less catastrophic.

In the epic battle between life's great certainties - death and taxes - there has always been a glimmer of goodness: At least when life ends, so ends the threat of income tax. Sure, the estate tax may bite into your legacy, but at least inherited assets are income-tax-free. Right?

That's the conventional wisdom. but there's one whopper of an exception. The "inherited property is tax free" mantra doesn't apply to money in a retirement stash, whether it's in an IRA, a 401(k) tax-deferred retirement plan, or a tax-sheltered annuity. Whoever gets the money will have to pay income tax on it.

• Leave your wife a $500,000 stock-and-bond portfolio - no income tax
• Leave your son that $150,000 beach house - no income tax
• Leave your daughter the $150,000 in your IRA - wham! Every penny will be taxed just as if you got it yourself. That means in her top tax bracket, perhaps as high as 39.6%. (Most states demand a share, too)

The bill can be staggering. If money in your retirement plans surge past the $1-million mark and your heirs are forced to withdraw it, state and federal taxes - income, estate and a special 15% excise tax for retirement plans - could take 96% of it, says Steven Lockwood, a financial planner and pension expert in New York City.

That's right, 96%.

You don't hear a lot about this problem because, until recently, it wasn't much of a problem. In the past, most company retirement plans sent monthly pension checks to retirees. That money is taxable, but generally the checks and the accompanying tax liability on them come to a screeching halt when the retiree (or his or her spouse-beneficiary) dies.

These days - with the advent of 401(k) plans, IRAs and rollover IRAs from 401(k)s - employees can accumulate stock piles of cash. That money, which may be the major component of your net worth, can be passed on to your heirs. Unfortunately, the tax bill is passed on, too. Understanding how and when the money will be taxed is the key to designing a strategy to keep as much as possible away from Uncle Sam. Decisions you make while you're still alive can control how fast the tax bill comes due after your death.

Stretching out the tax shelter
As long as your money is inside a retirement plan, it's safe from the IRS. So generally the best tax strategy is to keep the money in the plan and defer the bill for as long as possible. "It's the best tax shelter in the world," says Peggy Ruhlin, a personal financial planner in Columbus, Ohio.

But you can't leave it there forever. The law demands that you begin withdrawing funds - and paying taxes - no later than 1 April of the year after you turn 70 1/2 (only for traditional IRAs). The law is also very particular about how quickly the tax shelter must be liquidated after your death. That depends not only on who gets the money, but also on how old you are when you die.

The rules are appallingly complex, but here's an overview of what's what so you don't create unnecessary tax headaches for your heirs.

While you're alive and kicking
Until the year you reach 70 1/2, the IRS isn't pushy about your getting money out of your retirement account - in fact, there's usually a 10% early-withdrawal penalty if you tap an IRA before 59 1/2. Once you hit 70 1/2, though, withdrawals must begin at a pace at least fast enough to deplete the account by the end of your life expectancy or the joint life expectancy of you and your beneficiary.

A 70-year-ol has a life expectancy of 16 years, according to IRS tables. So one way to keep the IRS happy would be to take one-sixteenth of the balance in your IRA the first year, one-fifteenth of what's left the next year, then one-fourteenth and so on. If your 65-year-old spouse is your designated beneficiary, though the joint life expectancy is 23.1 years. That lets you stretch out withdrawals and the benefit of the tax shelter seven more years.

You can name anyone you want as your beneficiary, but picking an infant grandchild isn't the ticket to an extremely long payout. Unless your spouse is involved, the beneficiary is assume to be no more than 10 years younger than you for the purposes of computing joint life expectancy. So a 70-year-old father and 45-year-old son's joint life expectancy is calculated as if they were 70 and 60 (26.2 years), although their actual life expectancy is 38.3 years.

You can always take out money faster than required, but the IRS is very serious about getting its share of at least the minimum amount each year. If you - or your heirs - fail to take out what's required, an IRS penalty will relieve you of 50% of what should have been withdrawn.

If you die before age 70 1/2
The rules controlling how fast your heirs must withdraw funds from your account - and pay the piper - differ depending on whether you die before or after the first minimum withdrawal at age 70 1/2. If you die before then, here's how the law applies to various beneficiaries:

• Your spouse. Naming your husband or wife, if you have one, as your beneficiary provides the most flexibility because a surviving spouse has several options that are open to no other beneficiary.
  • ROLLOVER. He or she can roll over part or all of the money to her or her own IRA. That can really stretch out the tax shelter because your spouse doesn't have to start withdrawing funds until he or she turns 70 1/2. Your spouse can then name his or her own beneficiary, which leaves room for creating planning. One of Ruhlin's clients, for example, inherited her husbands $2 millions IRA and rolled it over into four IRAs, with each one of her four children named as the beneficiary of a separate account.
  • REMAINING A BENEFICIARY. Instead of a rollover, a surviving spouse can simply leave the money in the account. This makes sense if your spouse is under 59 1/2 and needs the money soon after your death. There's no 10% early-withdrawal penalty for taking funds out of your account, but that penalty would apply if the widow or widower rolled the money into his or her own IRA and tapped it before reaching 59 1/2. If your spouse remains a beneficiary, he or she doesn't have to start withdrawals until you would have reached age 70 1/2.
• Someone other than your spouse. Your child or other nonspouse beneficiary - including the beneficiary of a properly drawn irrevocable trust - gets two basic choices: Withdraw all funds from the account within five years after your death, or start withdrawals by the end of the year after your death and spread distributions over the beneficiary's own life expectancy. The second method would lengthen the payout period and keep the tax shelter going longer. The life expectancy for a 55-year-old, for example, is 28.6 years. Taking smaller distributions over a longer period might also hold down the IRS's take by keeping the beneficiary in a lower tax bracket. Again, remember that the required payout schedules set the minimum that can be withdrawn. The beneficiary can always take out more. (If you name your kids as a group, minimum payouts are based on the life expectancy of the eldest.)
• Your estate. Making your estate the beneficiary of your retirement nest egg is usually a bad idea. If you do so, all funds must be distributed to your heirs - and income taxes paid - within five years of your death. Heirs don't get the option of using their own life expectancy. The short payout period not only speeds up payment of the tax but can also push the recipients into a higher tax bracket

If you die after age 70 1/2
Once you take your first required payout, you make an irrevocable choice for calculating future minimum payouts. And your beneficiary (or lack of one) at that time "freezes the maximum payout period permanently," says Natalie Choate, a lawyer in Boston - unless the beneficiary is your spouse, who can roll over the account and set his or her own payout plan.

If you have no beneficiary or if your estate is your beneficiary, your heirs have to take the money at least as fast as you would have been required to. For instance, if you are tapping the account over a 16-year life expectancy and die after four years, then your heirs must deplete the account over the next 12 years.

Although you can add or change a beneficiary at any time, doing so after age 70 1/2 cannot slow down the payout schedule. At age 70 1/2 you must choose between two methods for calculating life expectancy.

• Fixed-term method. Under this plan, payouts are made over a fixed number of years based on your life expectancy - or the joint life expectancy with your beneficiary - when you're 70 1/2. If you choose this method and base payouts on your life expectancy alone, then your beneficiary receives distributions over the rest of your life expectancy. But if you use a joint life expectancy to calculate benefits, then your spouse or other beneficiary continues to get payouts over the longer term of the joint life expectancy
• Recalculation method. This method refigures your required minimum payout each year using your (or you and your beneficiary's) actual life expectancy. As you get older, your life expectancy increases. This method recognizes that reality and allows smaller minimum payouts than a fixed-term calculation. Some people choose this method to try and make sure that they do not outlive their money. However, there's a potential tax catch. Unlike your projected life expectancy, your actual life expectancy ends when you die. So if you base distributions on recalculating your life expectancy and don;t have a designated beneficiary, the entire balance must be paid out by December 31 of the year after the year you die. That guarantees there'll be a quick tax hit for your heirs. If you recalculate both your and your spouse-beneficiary's life expectancies each year, then when one of you dies, that person's life expectancy drops to zero and future calculations are based only on the survivor's life expectancy. This accelerates withdrawals. But the real hit comes at the survivor's death. That's when the entire balance must be paid out, and taxed, by the end of the following year. Of course, if your spouse-beneficiary survives you, he or she can always choose to take a lump sum and roll it over into an IRA, as discussed earlier. "A spouse rollover is a great way to clean up mistakes you made at age 70 1/2," says Choate

When choosing whether to slow down payouts during your lifetime by using the recalculation method, consider how important the option of delaying payouts will be to your heirs. In many cases they may be more interested in getting the money right away than in potential tax savings.

(remainder of article removed
as the information is no longer relevant)