Law News and Tips

IRA Planning

Fred Vilbig - Tuesday, March 01, 2016

IRAs and 401(k) plans are great. Amounts an employee contributes to them are tax-deductible up to certain limits. Amounts contributed to them by employers don’t even get included in taxable income when they’re contributed.

And then the amounts in these accounts grow tax-deferred. Even though amounts withdrawn are taxable, when taken out, the tax-deferred growth super-boosts your investment return, while the assets are sheltered in these accounts.

Once an account owner reaches 70 ½ years of age, he or she must begin taking the “required minimum distribution” (“RMD”). You calculate this RMD by dividing the amount in your account by your life expectancy. It’s kind of creepy, but the IRS has determined your life expectancy for you. That’s so kind of our government isn’t it?

When you die, if you’re married, your surviving spouse has the right to roll your IRA or 401(k) over into his or her own name. Assuming the surviving spouse is younger, then they can recalculate the RMD and extend the payment a little more. And all the while the money in the account continues to grow tax-deferred. Great benefit!

When I meet with couples, their biggest asset (or at least one of their biggest assets) is usually their retirement account. But the problem is that if the account owner doesn’t plan carefully, on the death of the surviving spouse, some of the benefits can be wasted.

For instance, I have had a number of estates where the couples failed to name a beneficiary of a retirement account. In that situation, the IRA is payable to the decedent’s estate. When that happens, all the IRA assets must be distributed within five (5) years, and all of these distributions will be fully taxable. You can lose 40% of the account value in pretty short order. It seems a pity to waste all those lifetime tax savings that way, but people do it when they don’t plan.

If people have a charitable inclination, a good plan is to have retirement assets payable to the charity. Although the retirement assets are taxable income to the recipient, since a tax-exempt entity is, well, tax exempt, no taxes are due.

If an IRA owner has children, a lot of people will just name the kids as the beneficiaries. This creates what is called an “inherited IRA” that can be stretched over the life of the recipient, which is a good thing.

But inherited IRAs can also be problematic. If the designated beneficiary dies before the IRA owner dies, then depending on the wording of the designation or the policies of the IRA administrator, the retirement assets may or may not go to the deceased beneficiary’s children and the measuring life will probably be that of the deceased beneficiary.

Inherited IRAs also present another problem. One of the laws that govern IRAs is the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. (Where do they come up with these names?). Under that law, an employee’s IRA is protected from bankruptcy. That much was pretty clear.

For several years after that, people wondered if the law also protected inherited IRAs. In the 2014 case of Clark v. Rameker, the Supreme Court decided that the law did not protect inherited IRAs. If inherited IRAs are not exempt from bankruptcy, I wonder if they are protected from a beneficiary’s creditors at all. I haven’t seen any cases on that, but it seems like a logical extension of the Clark case.

The way to protect inherited IRAs from a beneficiary’s creditors is to have the IRA paid to a trust. Now it can’t be just any trust. If the IRA can be used to pay the debts of the decedent, trust, or probate administration expenses, court ordered family allowances, various taxes, or other things, then the trust is not qualified and the taxes will be due within five (5) years.

In 1999, the IRS gave us some magic language to qualify a trust to receive IRA benefits. So in order for a trust to qualify, it must include this magic language. In addition, the trust needs to contain what’s called a spendthrift clause. This simply says that the assets of the trust cannot be used to pay the debts of the beneficiary.

An IRA paid to a properly drafted trust will protect the inherited IRA from the beneficiary’s creditors over the life expectancy of the beneficiary. It’s a good plan.

As you can see, IRAs are great retirement planning devices, but are a little problematic for estate planning. However, with a little planning, an IRA can continue to grow tax-deferred and benefit your children for years to come.

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