A couple of IRA beneficiary challenges.

Individual Retirement Accounts are great for one major reason… taxes are deferred until distributions are taken, sometimes on contributions and always on growth.

Deferral of taxation can be helpful in two ways:  First off, taxes aren’t coming out of the account to pay for regular growth, dividends and interest, so that money continues itself to generate growth.  Secondly, often people see themselves as being in a higher tax bracket during their working years than they figure they’ll be in during retirement.  Deferring income to a time when you may be in a lower income tax bracket makes a lot of sense!

It’s important to point out, however, that when an IRA account holder dies, his or her beneficiaries can continue to defer taxation, subject to rules that have emerged over time.

The most efficient means of ongoing tax deferral at death occurs when a taxpayer dies, and leaves IRA assets to his or her spouse.  In that situation, the spouse can opt to take over the IRA assets as their own, and these assets are treated as though they were already the surviving spouse’s assets.

When leaving these assets to survivors you’re not married to, the calculus changes.  However, non-spousal beneficiaries still have significant abilities to continue to defer taxation.  These beneficiaries can ‘stretch’ payments (and associated taxes) over the course of their lifetimes.

This is where some tricky issues can arise, though.  In order to stretch out IRA distributions over the course of their lifetime, the beneficiary needs to roll over the assets to an ‘Inherited IRA’ and each year calculate the required minimum withdrawal from the account based on an IRS formula.  If there are multiple IRA beneficiaries, the Required Minimum Distribution is based on the age of the oldest beneficiary (the one with the shortest life expectancy), so it benefits younger beneficiaries to carve out their portions into their OWN inherited IRA account (which needs to be done by December 31 of the year following the death of the IRA holder.).

Issues can arise, though when beneficiaries include ‘non-natural persons’.  This is someone (something, really) who doesn’t have a life expectancy, like a charitable organization or a trust.

CHARITABLE BENEFICIARY

Often, IRA owners who have a charitable intention at death will wisely choose IRA assets to leave to the charity.  The reason for this is that the charity won’t need to pay income taxes on the amount they receive, whereas living, breathing beneficiaries do have to pay income taxes.

Example: Mary has $400,000 in a bank account and $600,000 in an IRA.  She wants to leave $100,000 to her favorite charity, with the remainder going to her kids.  If she dies today, her kids will get $900,000, but if she gifts the $100,000 from the IRA, the kids will owe taxes on $500,000, whereas they’d owe taxes on $600,000 if she had gifted the charity out of the savings account!

Where we need to be cautious, however, is the situation where the charity is included as one of the beneficiaries with ‘natural people’.  Since a charity has no life expectancy, the remaining beneficiaries will lose the ability to stretch payments over their lifetimes and will have to take everything out within 5 years.  That can be avoided two ways:

1. Break up the IRA into multiple smaller IRAs and name unique beneficiaries for each. Make the charity its only beneficiary on a smaller account.
2. Even if this is not done, as long as the charitable beneficiary is completely paid out in advance of 12/31 in the year following the date of death, the remaining living, breathing beneficiaries can still take advantage of stretching distributions over their life expectancy.

 

TRUST AS BENEFICIARY

Often, IRA account holders have concerns about how and when beneficiaries receive their portions.  As such, instead of leaving beneficiaries assets outright, they name the beneficiaries in a trust document, and make the trust the beneficiary of the IRA.  This can have some benefits.  For example, someone concerned that their child, upon inheriting the assets, will need help in managing them has the ability to name a trustee to help with that and to make appropriate fiduciary decisions for the ultimate beneficiary.

The problem here is that, like with a charity, a trust also doesn’t have a date of birth, and thus no life expectancy.  This can ruin the ability of the beneficiary to stretch their income over a long time.  This, too, has remedies… The trust can be essentially disregarded and the distributions sent along over the course of the beneficiary life expectancies, provided it meets the requirements to be a ‘See Through’ Trust.  Those requirements are:

1. The trust must be considered valid and legal under state law, which typically means the creation of the trust document must be witnessed and notarized.
2. The trust must be irrevocable upon the plan owner’s death, meaning that the listed beneficiaries can be changed up to the point where the IRA owner passes away, but not after.
3. All beneficiaries must be easily identifiable, eligible, and legally named.
4. Documentation of the see-through trust must be provided to the custodian of the IRA by October 31 of the year following the IRA owner’s death. The regulations governing the trust and how it relates to the distribution of the IRA are part of 26 Code of Federal Regulations Section 1.401(a)(9).

Obviously, beneficiary designations are generally pretty simple and straightforward, but they do require care, especially in situations where non-humans are involved.  Proper planning can save huge tax consequences down the road!!