I was recently speaking with a one of my clients, and they had a very common question. "Dan, with what you are doing for us with our estate planning, how should we change our beneficiaries on our IRAs?" This is a very common question and leads to a lot of confusion between the financial advisor community and the legal services community. First, next to your home, an IRA is usually a family's most valuable asset. For a married couple, I rarely (if ever), recommend for the family's trust to be named as the primary beneficiary of their IRA account. The reason for this involves IRS tax rules. When an IRA transfers to a surviving spouse after death, the stretch out provisions are very favorable for the surviving spouse from a tax perspective. Therefore, it is not usually advisable to name a living trust as the beneficiary.
However, when a non-spouse is named as a beneficiary, the rules completely change from both a tax perspective and an asset protection perspective.
Generally, the IRS requires non-spouse beneficiaries to begin taking their required mininum distributions (RMDs) from the IRA that he or she just inherited beginning in the year after the year of death of the original owner. The first RMD must be taken from the newly established Inherited IRA by December 31 of that next year. For example, if the original owner died in 2017, then the first RMD must be taken by December 31, 2018.
As a non-spouse beneficiary, you must directly roll over the inherited assets to an Inherited IRA in your own name and use your own age and the IRS Single Life Expectancy Table for calculating the first year RMD. For each year after, you would subtract one year from the initial life expectancy factor.
If you do not take the required minimum distribution from your account, you will be subject to a penalty equal to 50% of the amount that should have been withdrawn.
However, if the original account owner died prior to age 70.5, you may choose to elect to use the five-year rule. Generally, this rule applies if the original owner died before April 1 of the year following the year the original owner would have turned age 70.5. If you take advantage of this rule, you do not have to begin taking RMDs in the year following the year of the original owner's death.
Under this five year rule, you can withdraw your inherited IRA assets at any time, and in any amount. However, you must withdraw all assets by December 31st of the fifth anniversary year following the IRA owner's death. As long as the account is depleted within this timeframe, the RMD penalites can generally be avoided.
However, under both scenarios described above, nothing prevents the adult children (non-spouse that inherited the IRA) from liquidating the IRA all at once, or faster than usual, and incurring significant tax consequences. Any amount of money that is withdrawn from an Inherited IRA is subject to ordinary income tax (which could push that individual into a higher tax bracket). It is for this reason, that many of my clients opt for naming their Accumulation or Conduit IRA Trusts as the contingent beneficiary. This is a planning strategy that forces their heirs to stretch out their distributions, restrict the liqudiation of the Inherited IRA, and allows the RMDs to accumulate inside the IRA. This allows the IRA to substantially increase in value over the lifetime of that non-spouse beneficiary.
In addition, the U.S. Supreme Court issued a decision in 2009 that says that Inherited IRAs are not protected assets. Therefore, these assets are subject to creditor claims, divorce claims, lawsuits, and other predators. This could create a situation in which the inheritance that you leave to your adult children is seized by future unknown creditors. It is for this reason that many of my clients opt to name their IRA Trust as the contingent beneficiary of their IRA accounts.
If you have questions regarding IRA Trusts and estate planning in general, please contact our office at (615) 472-2482 or e-mail us at [email protected] to schedule an initial consultation. We look forward to hearing from you soon!
Daniel A. Perry
Estate Planning Attorney