Retire Secure!

KEY IDEA

Individuals profit from deferring income taxes during their lifetime-so can their heirs.

Most people want to incorporate some planning for their heirs, beyond the needs of their spouse. Providing for the surviving spouse is usually the highest priority, but after the death of the survivor, you might hope to offer a cushion to children and/or grandchildren with the remaining funds. So, how does maintaining money in the IRA environment accomplish those two objectives?

Just as it was advantageous
for you to keep money in
your IRA, it is best for the
beneficiaries of IRAs to
retain the money in the tax-deferred
environment for
as long as possible.

Don’t pay taxes now—pay taxes later. Just as it was advantageous for you to keep money in your IRA, it is best for the beneficiaries of IRAs to retain the money in the tax-deferred environment for as long as possible. Starting with that premise, let’s examine planning for two types of beneficiaries.

For purposes of determining minimum distributions for inherited IRAs, there are two different types of beneficiaries.

Just as at some point you must take minimum distributions from your own IRA, the beneficiaries of your IRA must also take minimum distributions after your death. The distribution rules are different depending on your relationship to your beneficiary.

If your surviving spouse is your beneficiary, he or she will have three options at your death:

• executing a trustee-to-trustee transfer to his or her own new or existing IRA

2. Treat himself or herself as the beneficiary of an Inherited IRA from a spouse

Normally, the surviving spouse will choose the option of treating the IRA as his or her own. If your surviving spouse is happy with the financial institution holding your IRA, he or she can simply tell them to change the name on the account. If your surviving spouse is unhappy with the institution holding your IRA or with the investment choices available, he or she can complete a trustee-to-trustee transfer and move the IRA to a new custodian. An IRA spousal rollover is also a possibility. I prefer the trustee-to-trustee transfer rather than the spousal IRA rollover for the same reasons that I like the trustee-to-trustee transfer while the IRA owner is alive (see Chapter 6). If your surviving spouse elects this option, he or she can defer minimum distributions until age 70½. Any withdrawals taken prior to your surviving spouse reaching age 59½, however, are included in your beneficiary’s taxable income and are subject to a 10 percent premature distribution penalty.

Your surviving spouse also has the option to be treated as the beneficiary of your IRA. The account title will be changed to specify that you are deceased, and the IRA is for your spouse’s benefit. It is different from a joint account, because the title will look something like this: “IRA of Bob Jones, Deceased, For the Benefit Of (FBO) Carol Jones.” By electing this option, your surviving spouse will not be subject to the 10 percent penalty on any withdrawals he or she needs to make prior to age 59½. It allows flexibility if your survivor is younger than 59½, and might need additional income. As of this writing, there is no time limit restricting the surviving spouse’s ability to roll the Inherited IRA into his or her own account. Let’s assume that your survivor needs some income until his or her own pension starts at age 62. Your surviving spouse can withdraw income from your IRA prior to age 59½ without penalty until he or she turns 62, and then roll it into his or her own IRA so that he or she can defer further distributions until she or he reaches age 70½.

If your spouse disclaims your IRA, he or she refuses the right to inherit the assets, and they are transferred instead to other eligible beneficiaries. We’ll talk about disclaimers in detail in Chapter 14, but sometimes this is the appropriate course of action if your surviving spouse does not need the income from your IRA.

By default, your spouse will be considered to have chosen to treat the IRA as his or her own if they are the sole beneficiary of the IRA and if they make additional contributions to the account, or if they do not take a RMD for a year after inheriting the account. It is generally best for your surviving spouse to treat the IRA as his or her own rather than as an Inherited IRA. There are several reasons why:

If your surviving spouse decides to treat the IRA as his or her own, the tax treatment of the account is similar to what the original owner was experiencing. Only the distributions are taxed. The difference is that the future RMDs will be calculated from the Uniform Life Table based on the surviving spouse’s age. As I showed you in Chapter 5, this can be very important, especially if your surviving spouse is younger than you (it leads to a longer distribution period). The one exception occurs during the year the first spouse dies. If there is a RMD for that year, it will be based on the deceased spouse’s previous distribution schedule and must be withdrawn by the surviving spouse prior to completing the trustee-to-trustee transfer. That specific RMD becomes the property of the beneficiary, not the estate (that goes for non-spouse beneficiaries also). Finally, by assuming ownership of the IRA, your surviving spouse can name his or her own beneficiaries (usually your children and/or grandchildren who will become eligible to stretch the tax-deferral period over their individual life expectancies).

If the IRA is to be split among multiple beneficiaries, separate accounts should be established for each beneficiary after the first death. If separate accounts are not established, minimum distributions will be required based on the beneficiary who has the shortest life expectancy! Special care should be taken with the titling of the beneficiary accounts. Also, make sure to change Social Security numbers on the account.

There are situations when the surviving spouse might choose not to be treated as a surviving spouse but instead assume ownership of his or her deceased spouse’s IRA using the spousal Inherited IRA option. This strategy is usually made by people who don’t understand the implications or they would most likely opt to treat the IRA as their own. Choosing this option might make sense if your surviving spouse is at least 10 years younger than you, and he or she needs the money to live on. Treating your IRA as an Inherited IRA allows them to withdraw money without a 10 percent penalty, even if they are younger than 59½. Their future RMDs, however, will be based on a shorter life expectancy.

Now that you know what your options are if you inherit an IRA, we need to talk about stretch IRAs.

If you don’t really know what a stretch IRA is, don’t feel bad. Many readers and even many financial professionals could not give you a simple definition.

A stretch IRA is an IRA that has a beneficiary designation that provides for the possibility of maintaining the tax-deferred status of the IRA after the death of the IRA owner. You might be thinking, “I wish I had a stretch IRA. I only named my spouse as my primary beneficiary and my kids as my successor or contingent beneficiary.” Well, guess what? You have a stretch IRA. After your death, your spouse and/or your children could continue to defer income taxes for many years after your death, as long as the right moves are made by your heirs. If someone does something really stupid, without extreme precautions, they may ruin the stretch IRA.

I’ve talked at length about the importance of IRA beneficiaries, both here and in Chapter 5. Choosing the correct beneficiary for your IRA, and having your beneficiary make the correct choices after your death, are critical to providing your heirs with the ability to stretch your IRA for as long as possible.

If your surviving spouse chooses to treat your IRA as a Spousal Inherited IRA, the long stretch for the ultimate beneficiaries, usually the children, will be gone unless your spouse rolls the Inherited IRA into his or her own IRA at a later date (as long as that option is available). When your spouse acts as a beneficiary of an Inherited IRA, as opposed to treating the IRA as his or her own, the RMD will be calculated each year based on their life expectancy using the Single Life Table. That table gen erates big numbers, both in terms of the RMDs that deplete the account and in terms of the income taxes due on those RMDs. When your spouse dies, the beneficiaries who inherit the account will be locked into taking distributions based on your surviving spouse’s remaining life expectancy according to the Single Life Table, and the divisor will be reduced by one for each subsequent year. A full explanation of the rules and regulations for this option can be found below under the heading “Non-spouse beneficiary.”

A stretch IRA is an IRA
that has a beneficiary
designation that provides
for the possibility
of maintaining the taxdeferred
status of the
IRA after the death of
the IRA owner.

In my practice, we have come up with a compromise that works well when a surviving spouse is younger than 59½, and he or she needs the proceeds from the IRA for normal living expenses. First, we make a projection of how much money he or she will need until turning 59½. I include in the calculation some growth of the assets. Then we treat only that amount (the combination of his or her needs and the assumed interest and appreciation of those funds) as an Inherited IRA, and for the rest we do a trustee-to-trustee transfer. The advantages are clear:

Sometimes it is a delicate calculation to figure out how much the surviving spouse will need and what interest rates are likely to do. I would probably prefer to err on the side of overproviding for the surviving spouse until 59 ½, even at the expense of some income tax acceleration.

If you are uncomfortable with that approach because you don’t want to pay any extra taxes, you could underestimate and then plan to do a Section 72(t) periodic payment schedule before 59½ for a portion of the IRA that would be rolled over into the surviving spouse’s IRA. Section 72(t) payments, also known as Substantially Equal Periodic Payments, allow you to withdraw money from a retirement plan before age 59½, and still avoid the 10 percent premature distribution penalty. The catch is that the distributions have to be calculated so that they will be paid equally, over your life expectancy (or over the joint life expectancy of yourself and the IRA’s beneficiary). You are not allowed to take out extra money if you need it. Once you begin Section 72(t) distributions, you must continue taking them for five years, or until you reach age 59½, whichever comes later. Once you’ve started taking distributions, you’re locked in to taking them until you’ve been taking them for five years and you’ve reached age 59½. If you think that you’d like to change your mind and discontinue your 72(t) payments early, be prepared to pay substantial penalties and interest. Once you’ve been taking payments for five years and you’ve reached age 59½, you are allowed to discontinue the payments.

Spouses younger than 59½ who have a need for considerable money before they turn 59½ should seek professional help from someone who will run the numbers to help determine how to split up the IRA.

Another example when a spouse might choose to act as a beneficiary rather than assume ownership of the IRA occurs when the younger spouse predeceases the older spouse. The advantage here is that he or she may defer taking distributions until the IRA owner would have turned 70½. However, even though there might be some additional deferral period until the surviving spouse has to take the money out, I generally do not like this election. Unfortunately, when the time arrives to begin taking distributions, the surviving spouse must take out minimum distributions based on his or her sole life expectancy if he or she does not complete a rollover of the IRA.

If you die and the beneficiary of your IRA is not your spouse, he or she will own that special asset called an Inherited IRA. A non-spouse beneficiary may not roll an Inherited IRA into his or her own IRA, and cannot make additional contributions to the account. Assuming that you have drafted your beneficiary designation correctly (more about that in Chapter 16), and there is proper follow-through after your death, the beneficiary of the Inherited IRA will not have to pay income taxes on the account, at least not all at once. He or she will be able to stretch the Inherited IRA and take his own RMDs based on Table I (Single Life Table) found in IRS Publication 590.

The RMD for the beneficiary of the Inherited IRA is based on the beneficiary’s life expectancy as of December 31 of the year following the year the IRA owner died. Please note, however, that the beneficiary must be determined no later than September 30 of the year following the year that the IRA owner died. That might sound like a strange thing to say considering that the account owner has to fill out his beneficiary forms while he’s still alive, but what it really refers to is the idea that a beneficiary always has the right to disclaim, or refuse, the inheritance. Disclaimers can be very significant when planning your estate, and we’ll cover a lot more about them in Chapter 14. But for now, it’s just important to know that the IRS gives your beneficiaries almost two years to complete the process of transferring your IRA to your beneficiaries after your death. The reason for the September 30 deadline is to give the IRA custodian sufficient time to make the RMD before the end of the year.

Let’s look at what happens when the beneficiary of your IRA is not your spouse. Assume that Judy (from the Tom and Judy example described in Mini Case Study 11.1) is now a widow and cannot name her spouse as the beneficiary of her IRA. Judy names her six children as equal beneficiaries and then dies at age 88. For this example, assume that Judy had exactly $6 million in her IRA on December 31 of the year that she died. Each beneficiary’s share is $1 million, and separate accounts were established for each beneficiary. The RMD for each beneficiary of Judy’s Inherited IRA is calculated by dividing the balance in the account as of December 31 of the previous year by the life expectancy of that beneficiary. At the time of her death, her youngest beneficiary is 50, and her oldest beneficiary is 67. Judy’s oldest child would have a deemed life expectancy of 18.6 years (the life expectancy for a 68-year-old using the Single Life Table) for the first distribution, which would have to be with-drawn by December 31 of the following year. The RMD for the oldest child would be $1 million divided by 18.6, or $53,763. As the beneficiary (survivor) ages, the factor is reduced by one year, that is, the next year’s factor would be 17.6, then 16.6, and so on. Naming a younger beneficiary means a larger life expectancy factor and a lower RMD. The youngest child, who was 50 at the time of Judy’s death, has a more favorable outcome. He is still required to take distributions using the Single Life Table, but his deemed life expectancy at the time of Judy’s death is 33.3 years. His RMD in the year following Judy’s death would be $1 million divided by 33.3 years, or $30,030. His life expectancy is also reduced by one each year after, but his distributions are still spread out over a much longer period than his older siblings. Thus, a younger beneficiary who inherits an IRA will have a greater potential for long-term tax deferral than would an older beneficiary.

A younger beneficiary who
inherits an IRA will have a
greater potential for long-term
tax deferral than
would an older beneficiary.

Stated another way, the present value of the future cash flows to a younger beneficiary is greater than it is for an older beneficiary. Even when the surviving spouse uses a joint life expectancy (his or her life expectancy and a beneficiary 10 years younger) to calculate the RMD, the Inherited IRA has a greater tax-deferral potential for the surviving spouse’s child than for the surviving spouse. As the law stands right now, the inherited IRA would have its greatest tax deferral potential in the hands of a grandchild (preferably via a well-drafted trust). A younger beneficiary means a longer life expectancy. A long life expectancy equates to lower annual RMDs; the greater the portion of assets that remains in the tax-deferred environment, the greater the accumulation.

A long life expectancy
equates to lower annual
RMDs; the greater the
portion of assets that
remains in the tax-deferred
environment, the
greater the accumulation.

This may all change, however, and very soon. For several years, Congress has been looking for ways to reduce the tax benefits of stretch IRAs. They need tax revenue, and are trying to impose a finite term on the tax-deferred benefits of an inherited stretch IRA. In 2013, Senate Finance Committee Chairman Max Baucus proposed limiting the stretch to five years after death for non-spouse beneficiaries. Effectively, this would make the beneficiary pay all of the income taxes on the inherited IRA within five years.Thankfully for many of my clients, that proposal was withdrawn for lack of support. The idea reappeared, however, in April 2013 in President Obama’s budget proposals and made a grand entrance that summer when the measure was reintroduced as part of a bill to reduce student loan debt in the future. Killing the multi-generational benefit of the stretch IRA, along with a few other measures, would provide enough revenue to reduce student loan rates for college tuition for one year.

This bill was introduced in June of 2013 and was passed by the Republican House, but died in the Senate by a vote of 51-49 in favor of another bill to reduce student loan rates. President Obama wanted to sign it, but the Senate said no. After checking several sources and speaking with a well-connected colleague, it is becoming increasingly clear to me that this measure, or a similar one, may eventually pass – some say as early as 2015. The President’s 2016 budget contains the same proposition, and it will be interesting to see how the recent change in the dynamics of the Senate will affect his ability to get the measure passed.

The bottom line is that Congress, in its infinite wisdom, has decided that forcing your non-spousal heirs to pay income taxes on your entire IRA or retirement plan within five years of your death will provide them with a quick budget fix. Unfortunately, that fix may have dire consequences for your children or grandchildren.

Naming an estate as the beneficiary of your IRA is almost always a mistake because the beneficiaries of an estate do not qualify as designated beneficiaries for purposes of the RMD rules. Thousands of misguided souls will cause their beneficiaries massive income tax acceleration unless someone or something intervenes.

In order to achieve the maximum possible stretch for the beneficiary, you must have a designated beneficiary for your IRA. That used to be easier said than done. Now, it is hard to avoid, assuming you fill out the beneficiary form as recommended in Chapter 16. If the estate is named beneficiary of an IRA, a limited stretch for the remainder of the owner’s unused life expectancy is available if the owner dies after the required beginning date without naming a designated beneficiary.

There are many situations when a trust will be a good choice for a beneficiary of an IRA. The most common reason is if the beneficiary is a minor child. Even if the beneficiary is an adult child, we like to give the adult child the right to disclaim his or her rights to the account. In that case, having a well drafted trust for the benefit of the grandchild or grandchildren would be appropriate.

If your intended beneficiary is, or potentially will be, receiving public assistance of any kind, including Medicaid, you should consider using a trust. If they receive money outright as a named beneficiary, they may be disqualified from receiving future benefits. Naming a trust as your beneficiary might, under the right circumstances, allow your beneficiaries to continue the tax-deferral benefits of the stretch IRA. (This is very complicated. Please refer to Chapter 17 for more details).

You may want to use a trust if your beneficiary is not responsible with money and you want to make sure that he or she doesn’t do anything stupid with your money. This is typically called a spendthrift trust. If you want to ensure that the beneficiaries don’t spend all of your money at once, naming a trust as the beneficiary of an IRA will achieve your goal.

Another time you should consider a trust is if your child or children are involved in a marriage where divorce and/or other money issues are an important consideration. If you die leaving a large IRA to a married child and that child later goes through a divorce, it is possible your future ex-son or daughter-in-law could walk away with a portion of your money. In these situations, we have done a lot of trusts that we (tongue-in-cheek) call the “I don’t want my no good son-in-law to inherit one red cent of my money trust.”

There are a growing number of estate attorneys who routinely draft IRA beneficiary trusts for the benefit of the IRA owner’s adult children. They argue that the trust forces the beneficiary to get the stretch effect and the trust protects against creditors. Though I think there is good reason to support their practice, I personally prefer to keep things simple and flexible. Assuming that your adult children are financially responsible and aren’t experiencing financial or marital strife, I would prefer the default be to the children outright rather than a trust for the children. That way, you can avoid the trustee fee, and the accounting and tax return preparation fees associated with the trust.

Generally, we assume that a beneficiary will want to continue to defer income taxes after the IRA owner’s death. We also know that a drafting error in the trust or a procedural error could prevent this from happening and lead to a massive acceleration of income taxes.

It is important that any trust that will serve as the beneficiary of an IRA or retirement plan be drafted with extreme care to ensure that:

If those two qualifications are met, the life expectancies of individual beneficiaries of a trust can be used for purposes of the RMDs.

For the trust to qualify as a designated beneficiary (and get the stretch treatment), it must meet the following five requirements:

Depending on the ages of the beneficiaries, the amounts, and the individual’s situation, it may be worthwhile to establish a trust as the beneficiary of an IRA. If so, please be sure to comply with all the requirements so the beneficiary can enjoy tax benefits as well as the protection provided by a trust.

This is an area where an attorney’s input is advisable. Unfortunately, many attorneys, even estate attorneys, just don’t know this stuff. Since it is so easy to botch one of the requirements above, choose your attorney with care, and be sure to ask specifically about their experience with drafting a trust as a beneficiary of an IRA.

A Key Lesson from This Chapter

While you are alive, don’t pay taxes now—pay taxes later. The same advice holds true for your beneficiaries. I encourage you to discuss this concept with your beneficiaries so that they are aware of the material advantages of stretching an IRA. Now, we move on to the ultimate solution for estate planning with IRAs and retirement plans.

13

Laying the Foundation for Estate Planning

A man has made at least a start on discovering the meaning of human life when he plants shade trees under which he knows full well he will never sit.

— Elton Trueblood (1900–1994)