How to Integrate IRAs into Estate Planning

IRAs are among the most valuable assets in many estates. The right moves can maximize the after-tax value of the IRAs for the objects of your affection. Too often, not enough thought is given to the different ways IRAs can be handled in Estate Planning, so the value isn’t maximized. The IRAs don’t create the legacy they could.

The shortcomings are understandable. IRAs are simple during the accumulation years. Yet, they become complicated during the distribution years, and the estate planning strategies can be even trickier.

In this visit, we’re going to have a quick review of the basics of estate planning for IRAs. Then, we’ll look at some higher-level strategies that will interest many of you.

Remember that estate taxes usually aren’t the important issue for IRAs in estate planning. Income taxes are the issue. Distributions will be included in gross income of whoever receives them and taxed as ordinary income at the individual’s top tax rate. Most people want the IRA to last as long as possible to take advantage of its tax-deferred compounding and defer the taxes.

The top estate planning issue for IRAs and other qualified retirement plans is naming a beneficiary. Be sure to name at least one individual as primary beneficiary. You don’t want to leave the beneficiary designation blank, and you don’t want to name your estate. You also don’t want to name a trust as beneficiary unless it is the special “look-through” trust that allows for tax deferral. (See our June 2014 issue for details). If a beneficiary is other than an individual or look-through trust, tax deferral will be lost. The IRA will have to be distributed within five years.

Shortly we’ll discuss more considerations for beneficiary designations. But the basic rules are to be sure you have named at least one beneficiary, that it is an individual or look-through trust, and that you name only individuals or look-through trusts as primary and contingent beneficiaries.

Another estate planning basic for IRAs is to decide how much of your estate you want in a traditional IRA. We’ve discussed this in detail in the past. You might be able to reduce lifetime income taxes on you and your loved ones by emptying a traditional IRA early or converting it to a Roth IRA. This is especially true if you have a substantial IRA that you plan to leave to younger generations. For details of the factors to consider, you can review articles in the IRA Watch section of the web site Archive and my books, Personal Finance for Seniors for Dummies (with Eric Tyson) and The New Rules of Retirement.

Now, let’s look at some more advanced considerations.

Helping the Grandchildren

For many people these days, the grandchildren are their main concern. Their adult children either are doing well enough on their own or haven’t shown they would handle money well. The grandchildren face lifetimes of financial obstacles, and the grandparents would like the IRA money to be there down the road when the grandchildren need it.

In these cases, the best use of your IRA might be to name the grandchildren as beneficiaries, creating a stretch IRA.

A beneficiary who inherits an IRA must take required minimum distributions by Dec. 31 of the year after the year of the original owner’s death. The RMDs can be computed using the beneficiary’s life expectancy. With a grandchild, especially a young one, that RMD would be a minimal amount. It’s possible the investment returns would exceed the RMDs, allowing the IRA to continue growing. The bulk of the IRA might be available for the grandchild’s retirement, to help pay for a first home, or to pay for his or her own children’s education.

There are several factors to consider with this strategy.

When you have more than one grandchild and name them as co-beneficiaries, they are allowed to split the IRA into separate IRAs for each of them. That probably would be the smart thing for them to do. Or you can split the IRA into separate IRAs now and name one grandchild as the beneficiary of each. That would make managing the investments more complicated for you, and the IRAs probably would have different rates of return, resulting in different inheritances for the grandchildren. But it would ensure that the grandchildren don’t have conflicts from inheriting an IRA together.

Another factor is whether to leave them a traditional IRA or Roth IRA. If you have a traditional IRA and your main goal for it is to leave it to the grandchildren, they probably would be better off with a Roth IRA. The income taxes on today’s value would be paid by you, and that would ensure no income taxes on the grandchildren for life. They would benefit from the full value of the IRA, not its after-tax value. The longer the grandchildren will allow the bulk of the IRA to compound (while taking required minimum distributions) the more sense it makes for you to pay taxes now and let them have tax-free income for life.

A conversion is especially sensible when the value of the estate might be taxable. You reduce the size of your estate by paying income taxes on the conversion.

Of course, if you simply name the grandchildren as beneficiaries of an IRA, they’ll be able to do whatever they want after receiving title to it. IRA sponsors report that a majority of beneficiaries empty IRAs soon after inheriting them.

To ensure that doesn’t happen, you might need to name a trust as beneficiary of the IRA. In the trust terms you can determine how much will be distributed to the beneficiaries and when they’ll have access to the bulk of the IRA. To avoid the cost of a trust or if the IRA isn’t large enough to justify the expense, consider discussing your intentions and hopes with each grandchild and leaving each a letter repeating these points.

Disclaimer Planning

You can leave most of the decision making about the IRA to your survivors if you plan properly. They can use disclaimers to decide who ultimately benefits from the IRA.

A disclaimer is a when a beneficiary turns down, or disclaims, the inheritance. When that happens, whoever is next in line in the beneficiary list takes the disclaimed person’s share.

For this to work you first have to name one or more primary beneficiaries. Then, you name contingent beneficiaries. These are the people who inherit the IRA when for some reason one or more primary beneficiaries don’t.

Here’s how it might work. You name your spouse as primary beneficiary of an IRA, an adult child as contingent beneficiary, and a grandchild as secondary contingent beneficiary. After you pass away, your surviving spouse concludes that he or she has sufficient income and assets and doesn’t need the IRA. The spouse disclaims the IRA inheritance. Your adult child decides that he or she already is financially comfortable and doesn’t need the IRA. He or she also disclaims. The grandchild then inherits the IRA. That’s a simple example. You can add a lot more people to the mix.

This provides a lot of flexibility and allows for contingencies. If your spouse suffers a financial hardship just before or after your passing, he or she doesn’t disclaim. The grandchild inherits only if your surviving spouse and adult child are financially secure.

For disclaimer strategies to work, you first need to work with your estate planning advisor on the details and possible scenarios. Of course, you need to discuss the idea with the named beneficiaries to ensure they are aware of your intentions and will go along with them. A process needs to be set up for determining who would be the optimum person or persons to inherit.

Keep in mind that only someone who is named as a primary or contingent beneficiary can inherit under a disclaimer strategy. Your heirs can’t decide afterwards to add someone to the list.

Charitable Giving Strategies

When a charitable bequest will be a meaningful part of your estate, consider making the gift with all or a portion of your IRA. You and your heirs will reap benefits.

IRAs are treated differently than other inherited assets. When most non-IRA assets are inherited, the beneficiary increases the tax basis to the current fair market value. If someone inherits an appreciated mutual fund, stock, or property, it can be sold immediately without incurring any capital gains taxes. The appreciation during the previous owner’s lifetime never faces capital gains taxes.

An IRA, however, has no step-up in basis for the inheritor. Distributions from a traditional IRA are taxed as ordinary income just as they would have been for the original owner. The beneficiary also has to take required minimum distributions, so there’s never full tax deferral.

When a charity is named beneficiary of an IRA, however, the charity doesn’t owe taxes on distributions, because it is tax-exempt. The value of the IRA is included in the estate, but the portion allocated to the charity is deducted from the value of the estate. That reduces federal estate taxes if the estate is large enough to be taxable, and also can reduce any state death taxes.

When you own a traditional IRA and plan to make meaningful charitable contributions through your estate, it makes a lot of sense to make the charitable gifts through an IRA and leave other assets to the non-charitable beneficiaries if the composition of your estate allows. Your heirs inherit only the after-tax portion of a traditional IRA. The charity benefits from the full value of the IRA because of its tax-exemption. Everyone is better off when the charitable gift is made through the IRA and heirs receive other assets.

You can move assets designated for the charity to a separate IRA. Or you can name the charity as co-beneficiary of an IRA with others and have the beneficiary designation form state how much the charity will receive, whether it is a dollar amount or a percentage of the IRA.

The strategies discussed here aren’t do-it-yourself strategies. You should have the guidance of an experienced estate planning professional before implementing them.