Leaving an IRA to a loved one? How to avoid a tax bomb

This post was originally published on this site

You wouldn’t trust your toddler with a pile of cash, right? Well, this estate-planning technique may allow you to safely pass your IRA on to future generations — if you do it right.

When it comes to naming a beneficiary of your retirement account, the first person to come to mind is likely your spouse. Your kids, if you have them, might be a close second.

However, your children or grandchildren won’t always be in an ideal position to receive a windfall, particularly if they are minors, disabled or spendthrifts.

That’s when a trust might make sense.

“The real reason for having a trust as an IRA beneficiary is because there’s some element of control,” said Ed Slott, a CPA and founder of Ed Slott & Co. “People who name trusts as beneficiaries are doing it to protect a very large IRA.”

It’s easy to mess up this, however.

In the first place, not all IRA custodians permit you to list a trust on your beneficiary form.

Second, the tax code has a specific list of conditions for trusts that act as beneficiaries to retirement accounts. Failure to closely follow the IRS rules could result in an accelerated distribution of your IRA and a raft of taxes.

Here’s what you should know.

In order for a trust to be viable as a designated beneficiary, it must meet a four-part test.

1. It must be valid under your state’s law.

2. It must be an irrevocable trust — a trust that generally can’t be changed once it’s established — or one that will become irrevocable at your death.

3. The beneficiaries must be identifiable from the trust document.

4. The IRA custodian or retirement plan administrator must have received a copy of the trust by Oct. 31 of the year following the year of the IRA owner’s death.

There is an unofficial fifth rule, according to Slott: All of the trust beneficiaries must be actual people — not charities and not your estate.

That’s because if your beneficiaries aren’t people, then your IRA may not have a designated beneficiary at all.

In that case, your heir misses out on a key estate-planning strategy that will allow her to “stretch” the inherited IRA by taking required minimum distributions based on her much longer life expectancy.

Even worse, if your trust fails the test, it’s subject to the rules that kick in when you have no designated beneficiary for your IRA.

That means your retirement account will be depleted earlier than you would have intended.

If you die before you start taking required withdrawals, which start at age 70½, your IRA must be distributed within five years after you’ve died.

If you die after you started your RMDs, then your distributions will continue to pay out over what would have been your remaining (and presumably shorter) life expectancy.

The type of trust you select as a beneficiary matters. There are generally two to choose from.

A conduit trust distributes the IRA’s RMD directly to the beneficiary.

“Grantors often set up a conduit trust if they trust the child, or if the child isn’t in a high-risk profession,” said Stephen Bigge, a CPA and partner with Keebler & Associates.

If you’re worried that your child is a spendthrift or that creditors may try to seize the money, consider a discretionary trust.

In this case, RMDs pass from the IRA to the trust, and the amount of money that passes to your beneficiary is ultimately up to your trustee.

Be aware of a potential tax trap here: RMDs are taxable income to the beneficiary when he receives it, but if the distribution is held in the trust, then the trust will owe the taxes.

Consider that in 2019, the top marginal income tax rate of 37 percent is at $510,301 in taxable income for singles and head of household ($612,351 for married filing jointly).

On the other hand, the 37 percent tax rate for trusts kicks in at $12,751 in taxable income.

This can present a conundrum for the trustee overseeing a discretionary trust, especially if the beneficiary can’t be trusted with the money.

“It’s an income tax versus fiduciary responsibility issue,” said Bigge. “You have a $50,000 RMD. Will the trust give the money to the kid or not?”

Perhaps you have several children, and you’d like to pass your IRA proceeds through a trust for their benefit.

The best way to proceed is to consider creating a trust for each child.

Separate trusts allow each beneficiary to have RMDs based on his or her own life — and they also reduce strife among heirs.

“The beneficiaries might also have different cash flow needs and different tax loads,” said Tim Steffen, director of advanced planning at Robert W. Baird & Co. “One might want to take the money out, the other wants to leave the money in.”

Be sure that your trust documents clearly state the names of the beneficiaries, so that it meets the IRS four-part test.

“It’s better to name the kids individually than to do something like ‘for the benefit of my three children,'” Steffen said.

Naming a trust as the beneficiary of an IRA isn’t for beginners. Coordinate with your estate-planning attorney and accountant before you proceed.

That way, you can be sure to avoid these common errors:

Inadvertently placing the IRA in the trust: If you write a check from the IRA to the trust, then you’ve botched the “stretch” IRA and you’ve just made a taxable distribution.

Instead, set up a properly titled inherited IRA, said Slott. He provided an example of how it should look. “John Smith, IRA Deceased 11-15-18 f/b/o, John Smith Family Trust, beneficiary.”

This way, you preserve the IRA and the only money that goes to the trust is the RMD.

Failing to review your beneficiary forms: Why go through the work of setting up a trust if you’re going to omit the key step of naming it as the IRA beneficiary? Revisit your beneficiary designations and make sure they reflect your wishes.

If you have separate trusts for your beneficiaries, name them on the form.

Being vague about your trust details: Specificity is everything. Be sure that your trust beneficiaries are identifiable by name, and make sure that they are people — not charities and not your estate.

More from Personal Finance
You don’t have to lift a finger to join this savings plan, but it can backfire
Claiming a tax deduction for medical expenses is getting harder
10 states where you can make the most money from real estate

Subscribe to CNBC on YouTube.

Add Comment