Estate Planning and IRA’s

A retirement account can be the key to long-term financial security. It also can be a person's largest financial asset, if not in the present at least in the future. After recovering from the dramatic downturn in the stock market in 2008, some investors are regaining their optimism as stock prices climb. Over the long term IRA's (and 401(k)’s)are probably one of the best ways a person can provide for a more secure future and possibly avoid inflation eating into the real value of his or her wealth.

Estate planning as to a retirement account starts from two basic facts: (1) at death the account passes to a designated beneficiary and (2) income tax has been deferred for a retirement account (except for Roth IRA's). It must be paid when money is distributed from the account, whether that happens before or during retirement, or after the death of the account holder.

A note as to terminology: In this discussion I am going to use IRA's to refer collectively to all tax deferred retirement accounts because (1) the law is generally the same for IRA's and these other accounts; and (2) an employee upon retirement or leaving a job can usually convert a 401(k) and other pension accounts to an individual IRA. Most experts suggest rolling over a 401(k) or other employer-provided account to an IRA upon retirement or changing employers.

The Federal Estate Tax is less of a threat to large IRA's as it was in previous years. As of January 1, 2020 each person can pass about $11.5 million of assets to the next generation free of the Federal Estate Tax. That exempt amount will revert after December 31, 2025, to the figure under the previous tax law, which should be no less than $6 million. Of course, Congress can write another “tax reform act” before January 1, 2026 and preserve the higher figure.

The Federal Estate Tax (sometimes referred to as the "death tax") is imposed on a person's wealth, their retirement accounts and any life insurance death benefits from policies owned or controlled by the decedent. Any assets going to a surviving spouse are usually protected by an unlimited marital deduction, which simply means that imposition of the death tax is postponed until the death of that surviving spouse, the "second death."

A surviving spouse has the option of rolling over an IRA into his or her own IRA account, thus postponing the income taxes until money is withdrawn from the new account, which ideally is when that person has retired. No other beneficiary can do a rollover.

Thus it is usually a no-brainer for a person to name their spouse as primary beneficiary of their IRA. But what about the "backup" beneficiary? If the account holder has minor children, there can be problems. Minors cannot own such property in their own name. This legal disability is why people create trusts to hold assets for their children until they are older and (hopefully) wiser.

If you go to the trouble of setting up a trust for the children (even if it is only through your will -- a "testamentary trust"), should you name that trust as beneficiary of the IRA? The answer is probably yes. However, any trust that is named as the beneficiary of an IRA must be drafted very carefully because of the income taxes on the account. Until January 1, 2020, the trustee of such a trust for the children could “stretch out” the distribution of the retirement assets based on the life expectancy of the beneficiary. Because of a law enacted in December 2019, with few exceptions that is no longer possible for a non-spouse beneficiary. In most cases the account must be distributed in full and the income taxes paid within 10 years of the death of the account holder. (Roth IRA’s must be distributed but no income taxes will be imposed on the distributions.)

Some people are not in the clear even after their children are grown up because they have "blended families," with children from previous marriage(s). Naming a surviving spouse as the beneficiary creates a risk that the children of the original account owner will never see any of the IRA money because the surviving spouse can rollover the account and name new beneficiaries. If the IRA is large enough it might be worthwhile to name a trust specifically drafted to pay all IRA distributions to the surviving spouse and upon his or her death then to the children.

One pitfall to avoid is failing to name a beneficiary, in which case the estate of the account holder will most likely become the IRA beneficiary. That will be a real mess if that deceased account holder died without a will.

Now that I have covered the problems, what is the solution? It would take a fairly thick book to discuss plans for the most common scenarios. I know because I have such a book on my shelf. A list of possible beneficiaries is the following: surviving spouse, custodian for minor children, children outright, a specially drafted trust and/or a charity. In may be necessary to name such beneficiaries in order of priority instead of all together. Thus the beneficiary designation language may be as complicated as the language in the will. As the sergeant used to say on the TV series Hill Street Blues, "Be careful out there."