IRA and 401k distribution planning is absolutely one of the most overlooked areas in estate planning today. According to the IRS, over 90 percent of all IRA-type accounts are cashed in at the death of the second spouse. When this happens, it triggers income and estate tax that could wipe out, in Tennessee, as much as 70 cents for every dollar that is in the IRA.
Obviously, if this is happening 9 out of 10 times, there is a major problem with the planning. There are two reasons that it creates these problems:
First is the taxation that is due on the IRA accounts. It is very important to realize that when you look at your IRA and 401k balances, none of the income tax has ever been paid on those accounts. At some point, somebody's got to pay the tax. There is no exemption for the income tax due on a retirement account. If it's $1 in there, your kids will pay taxes on a dollar. There is no exemption like you have for estate taxes. If it is cashed in, it triggers all of the income tax.
On top of that, there is a completely separate process for passing on retirement accounts to heirs. That's because when you name a beneficiary on an account, the asset will pass directly to that beneficiary. It does not go through your will, and if you have named a beneficiary, it does not go through your trust.
Many estate planning professionals recommend that you create or name your living trust as beneficiary for an IRA.
There are really only a couple of reasons to consider naming a trust. One of the great things about IRAs is that your children can inherit them, and they don't have to cash the account in right away. Instead, they can stretch the tax deferral of that IRA across their lifetime. This is known as a “stretch IRA.” Then, every year starting the year after the parents have passed away, this child has to take a small amount out, based on his life expectancy. The idea is he can stretch the benefits of that account across the rest of his lifetime, which will effectively lower the tax bracket and maintain that tremendous triple compound interest you get with tax deferral.
The problem is the “living” part of a living trust. In order to qualify for a stretch IRA and maintain that tremendous tax advantage while not being hit with a tax burden, you have to have a life expectancy. A living trust has no life expectancy that can be measured. So most living trusts do not qualify for a stretch IRA.
There are reasons to use a trust, but they are very, very specific. Making a trust the beneficiary is not a one-size-fits-all solution when you're leaving money to the kids. A primary reason is to provide restrictions on the account so the children cannot cash the account in all at once.
Perhaps you are fine with your kids getting the money, but you don't want to leave it to your grandchildren, who could make the mistake of cashing it in at a very young age. That's when you would name a special kind of a trust–a retirement account trust–as the beneficiary. But it has to be drafted in a specific way to meet IRS guidelines to be able to qualify for a stretch IRA and not have the IRS become one of your primary beneficiaries–which would be a major mistake.
Naming a trust as beneficiary of a retirement account is much more complicated than it may seem. If done incorrectly, naming a trust as beneficiary could expose you to tax penalties, an unplanned tax bill for your heirs, and loss of the tax structure of the IRA or 401k.
Here are some guidelines to follow when naming a trust as beneficiary for your retirement accounts:
- Should you name a trust that holds or will inherit other assets?
- A separate trust should be set up to handle distributions from your IRA or 401k upon death. Because retirement account assets have a complex set of rules for distribution, mixing them with other assets creates a greater likelihood that mistakes will be made, and these mistakes can trigger high taxes on the account. It is best to use a separate trust to inherit the IRA-type accounts. If you have multiple beneficiaries, it is usually best to name a separate trust for each beneficiary.
- Is the trust properly named as beneficiary for your IRA/401k?
- The beneficiary form holds complete control over the ultimate distribution of your retirement account. Be sure that you comply with your IRA or 401k custodian’s rules, and be sure to keep a copy of the beneficiary form for your records.Should you have the retirement account balance transferred to the trust upon death?
Having the balance paid to the trust at death will trigger all of the income taxes on the account. Instead, the retirement account should be re-titled as an inherited IRA for benefit of (fbo)
the trust. Required Minimum Distributions are then paid to the trust annually, and are ultimately distributed according to the rules in the trust.
Naming a trust as beneficiary for your IRA or 401k is a delicate process, and IRA distribution planning is the most overlooked area in estate planning today. To ensure success, be sure you are working with a professional who specializes in this unique field.
BIO: Jim Brogan is a well-known financial educator, author and talk-show host. His radio show, “Well Preserved with Jim Brogan,” can be heard every Sunday morning at 7:00 on FM 100.3 WNOX. Mr. Brogan is a highly sought-after instructor, and he is considered by many to be on the country’s top experts on the complex rules governing distributions of IRAs, 401Ks, and other retirement accounts. Earlier this year, Jim was accepted into the nation’s most exclusive group of financial advisors – Ed Slott’s Elite IRA Advisor Group.
Jim Brogan is the president of Brogan Financial, Inc., a local firm that specializes in Comprehensive Wealth and Distribution Planning. He can be reached at 865-862-6800