Unique Estate Planning strategies are required for Individual Retirement Arrangements. Many people focus on how to build their IRA balances and how much to withdraw. The treatment of IRAs in estate planning often is overlooked.
An estate plan for IRAs should answer these questions: What will be the estate tax and income tax bills? Who will pay those taxes? Who will receive the IRA? In what form will the IRA be received?
The value of the IRA will be included in the owner’s estate. That is impossible to avoid. The IRA cannot be given away during life or put into a trust. If the IRA owner’s estate will be large enough to incur estate taxes, the owner has plan with other assets to reduce the tax or purchase life insurance to pay the estate tax. Most likely the IRA also will incur any state death or inheritance taxes.
Estate taxes can be avoided when the surviving spouse is the sole primary beneficiary of the IRA. The IRA’s value will be included in the estate but there should be an offsetting marital deduction.
When estate taxes are incurred, the next issue is who pays the taxes attributable to the IRA.
Most standard wills provide that estate taxes are paid from the residuary estate or from the surviving spouse’s share. Other estates apportion the taxes against specific assets or shares of the estate. If the IRA is a large percentage of the estate and taxes are paid from the residuary estate or surviving spouse’s share, the taxes could really shrink those shares of the estate.
Having the taxes paid by the beneficiaries of the IRA could create problems. If the beneficiaries do not have sufficient other assets to pay the taxes, they will have to take a distribution from the IRA to pay the taxes. The distribution will be included in gross income, so they will have to take an extra amount to pay the income taxes on the distribution they take to pay the estate taxes.
The best solution depends on the particular estate. The IRA owner should take care to consider how much the estate taxes will be and which part of the estate will pay them or whether life insurance should be purchased to pay the taxes.
Unlike when other assets are inherited, there also will be income taxes due when the beneficiary takes distributions from the IRA. The beneficiary pays the same income taxes on distributions that the owner would have paid. These taxes cannot be avoided, and the fact of them might influence who is named beneficiary of the IRA or how much is left to different beneficiaries.
A non-IRA asset is more valuable to an heir than an IRA of equal value, because there will be income taxes on distributions from the IRA. The non-IRA asset can be sold and no capital gains taxes would be due on the appreciation that occurred during the owner’s holding period.
The income taxes due on IRA distributions are a reason to consider making charitable gifts with the IRA rather than with other estate assets. The IRA will be included in the estate, but there will be an offsetting charitable contribution deduction, for no net tax. A charity that is named beneficiary of an IRA will not owe income taxes when it takes distributions. If there is an inclination to make charitable gifts through the estate, it often is better to make the gifts through an IRA and maximize the non-IRA assets left to other heirs.
An IRA owner wants to be sure to name one or more beneficiaries. Failure to do so, or naming the estate, removes the tax deferral benefits of the IRA. Distributions will be required from the IRA on an accelerated schedule.
Naming the beneficiary is not as complicated as it used to be. Before 2001 and 2002 regulations, the beneficiary choice greatly influenced the amount of required minimum distributions. Now, an IRA owner should consider only who is most likely to need the IRA.
In most cases, the surviving spouse is the primary beneficiary and the children are contingent beneficiaries. In larger estates, the owner might name a charity to receive at least some of the IRA as discussed above.
It makes a lot of sense for an IRA owner to have a back up plan. The regulations allow the estate executor to name the Designated Beneficiary by September of the year after the year of the IRA owner’s death. In most cases, there won’t be any reason to change from the standard practice of naming the surviving spouse as beneficiary. But circumstances can change, and the regulations allow the executor to adapt to changing circumstances.
For the executor to take advantage of this situation, the IRA owner must name contingent beneficiaries on the beneficiary designation form. The Designated Beneficiary named by the executor must be on the list of primary and contingent beneficiaries named by the owner.
The beneficiaries can split the IRA into separate ones after inheriting it, but they might not realize this or the IRA custodian might be resistant to it. It might be better for the owner to split the IRA. If the beneficiaries do not split the IRA, the age of the oldest determines the required minimum distributions from the IRA. In addition, the beneficiaries have to agree on management of the IRA and on taking distributions that exceed the required minimum.
Instead of leaving the IRA directly to individual beneficiaries, the owner might want to name a trust as beneficiary. The trust can control when distributions are made to the beneficiary. This arrangement might increase income taxes, however, and tricky rules must be followed when drafting the trust. Do not name a trust as IRA beneficiary without working with an estate planning attorney who is experienced in this area.
Because of the income and estate taxes and the nuances of naming beneficiaries, some IRA owners choose to empty their IRAs early, pay the taxes, and invest the after-tax assets in taxable accounts. Once out of the IRA, the assets can be given away as part of the estate plan or can be invested for long-term gains.
Emptying the IRA early generally is a strategy for those who have sufficient assets outside the IRA or a very large IRA and consider the IRA primarily a savings account or something to be left to the next generation. If the strategy used, it is best to empty the IRA as early as possible, because time is needed to make up for paying the income taxes early. I discuss the strategy in detail in my book, The New Rules of Retirement, and there are some articles in the Archive section of the web site.
For similar reasons, people convert traditional IRAs into Roth IRAs. Details of when to consider this strategy also are in my book and the Archive.
IRA owners need to know that wills and living trusts have no effect on an IRA. Only the beneficiary designation form on file with the custodian determines who inherits an IRA. IRA owners need to keep copies of the form and review it regularly. They also should check with the custodian to be sure it has the current form.