An Individual Retirement Account (“IRA”) is a type of investment account that allows an individual to save money for retirement, with the earnings on the account potentially being tax deferred until they are later withdrawn at retirement. (Withdrawals from a Roth IRA can actually be tax free provided certain conditions are met).
In addition to the benefit of tax deferment of the earnings, contributions to a Traditional IRA can often be tax deductable, and the rules for deductibility vary depending upon a participant’s marital status and modified adjusted gross income. Contributions to a Roth IRAare not tax deductable because they are made with money on which the individual has already paid taxes.
Passing on IRA Benefits After Death
IRAs are a common retirement tool for many people. But what happens to the remaining proceeds of an IRA account when the owner dies? Many individuals assume that their IRA account will be distributed pursuant to the terms of their Last Will and Testament, with the account becoming part of their probate estate. But the truth is that many IRA accounts are not subject to probate because the plan participant had established a beneficiary designation on the account during his or her lifetime. Establishing beneficiary designations on an IRA account can be a good way of keeping the asset out of probate, but it’s important to understand the pros and cons of the different beneficiary options.
Designating a Spouse as Beneficiary of an IRA
There can be significant advantages in naming a spouse as the primary beneficiary of an IRA. Upon the account owner’s death, the spouse often has several options. For example, he or she can roll over the account into a new or existing IRA and defer distributions until reaching age 70½. Or, once the IRA has been rolled over and a new account established, the surviving spouse also has the option of converting it to a Roth IRA. Or say the surviving spouse is under 59½ and would like to access the funds immediately without incurring an early withdrawal penalty, he or she would have the option to transfer the asset into an inherited IRA. The options available to a surviving spouse, and the laws that apply to those options, are far beyond the scope of this article. But it is important to explore those options and to understand the opportunities available. If an IRA owner doesdecide to designate his or her spouse as the primary beneficiary of the account, it is recommended that a contingent beneficiary designation also be established, just in case the account owner’s spouse predeceases him/her.
Designating a Non-Spouse as Beneficiary of an IRA
A non-spouse beneficiary has the option of transferring the assets into an inherited IRA, and withdrawing the required minimum distributions from the account each year. These distributions can be stretched out over the life expectancy of the beneficiary, which can potentially allow the investment to grow tax deferred for several years. (A Roth IRA would grow tax free during this period). There are other options available to a non-spouse beneficiary depending upon his or her age, the age of the IRA owner, the type of IRA, and the beneficiary’s particular circumstances. Therefore, it is important to promptly consult with your tax and financial advisors upon learning that you are the beneficiary of an IRA.
Designating a Trust as Beneficiary of an IRA
Some of my estate planning clients express concerns about designating their children or other relatives as the direct beneficiaries of their IRA accounts or other assets. They worry about their beneficiaries’ potential debts, judgments, legal issues, divorces, or medical issues, or about the possibility of jeopardizing the government benefits of those beneficiaries eligible for means tested benefits. Other clients are simply concerned about their beneficiaries’ ability to manage the assets being passed on to them. For clients expressing such concerns, I often recommend that they explore the possibility of establishing a revocable trust as part of their estate plan. The client’s assets, including IRA accounts, can be directed to the trust by naming the trust as the beneficiary. Once the client has died, the assets owned by the trust, or passing to the trust by beneficiary designation, are not vulnerable to the creditors and legal problems of the beneficiaries, provided that the trust is properly drafted.
Despite the attractive protections offered by a trust, there can be disadvantages when naming a trust as a beneficiary of a tax deferred asset such as an IRA. Problems can arise if a trust named as the beneficiary of an IRA does not meet the legal requirements established by federal regulations to qualify as a see-through (or look-through) trust. If a trust does not meet these requirements, it may be required to take the payout of the IRA within as little as 5 years if the account owner had not yet reached the required IRA withdrawal start date before he or she died. If the owner died on or after this date, a trust could receive distributions based upon the owner’s remaining life expectancy as if the owner was still alive.
IRA Trusts
For those clients who wish to take advantage of the benefits a trust can offer to protect their assets for their beneficiaries, while still allowing the distributions of an IRA inheritance to be stretched to receive the benefit of tax deferment, a qualified see-through trust can satisfy their goals. Provided that a trust contains the necessary provisions, it will be treated as a qualified trust, permitting the IRA to be stretched out over the life expectancy of the oldest living beneficiary. These trusts are often referred to as a conduit trust. If separate sub-trusts are created for each beneficiary under the main trust, and the proper beneficiary designations are established, each beneficiary of the trust can receive IRA distributions based upon his or her individual life expectancy.
For those clients who wish to have the option of retaining IRA distributions in trust for purposes of protecting the proceeds from the creditors and legal problems of their beneficiaries, an accumulation trust may be appropriate. However, accumulation trusts can complicate the matter of determining the potential beneficiaries for determining the measuring life for tax deferment purposes. Furthermore, if the required minimum distributions paid to the trust are not distributed to the primary beneficiary within the year of receipt, the proceeds retained by the trust will be taxable at the trust’s tax rate, which is usually higher than a beneficiary’s individual tax rate.
While conduit trusts can maximize income tax deferment for beneficiaries, an accumulation trust may accomplish the most asset protection. When considering either type of IRA trust, it is important to consult with a qualified estate planning attorney. Contact Attorney Stephen Kosa today to understand your options.