IRA DISTRIBUTION OPTIONS AFTER DEATH
When an IRA owner dies and leaves their IRA to a non-spousal beneficiary, under current law the IRA generally must be distributed under one of three alternatives:
- Lump Sum – Full distribution of account balance. This option could potentially bump the beneficiary into a higher income tax bracket.
- Five-Year Rule – Entire account balance must be distributed by Dec. 31 of the year containing the fifth anniversary of the IRA owner’s death. The rule does not require equal or annual distributions over the five-year period.
- Life Expectancy – Beneficiary may spread distributions over his or her life expectancy. Often referred to as a Stretch IRA, this option can stretch out the withdrawals over decades, even lifetimes, avoiding large income tax bills and providing tax-deferred growth.
One of the most powerful tools in the IRA owner’s toolkit is the ability to stretch an inherited IRA over the beneficiary’s lifetime. This allows the majority of the IRA assets to continue to take advantage of tax-free accumulation. With over $7.8 trillion held inside IRAs, the power conveyed by the IRA stretch is nearly limitless.1
CONSIDERATIONS
I’m not going to cover the technical details of Trust Owned Inherited IRAs. You absolutely need an attorney with experience drafting these kinds of trusts to make sure it qualifies under the tax code as a Conduit Trust.
Additionally, an Inherited IRA owned by a trust is one of the most complex structures you will come across from an administration standpoint. Not just because of the tax and legal issues, but finding a banker, financial advisor, investment company, etc. with the proper administrative experience will prove challenging.
BENEFITS OF TRUST OWNED INHERITED IRAS
The Supreme Court decided that after the death of an IRA owner, assets in an inherited IRA for a non-spouse beneficiary no longer are not protected from creditors’ claims when a non-spouse beneficiary files for bankruptcy. However, an IRA owner may create a spendthrift trust and designate it as beneficiary and the heirs can be made beneficiaries of the trust.
Additionally, using a trust will provides creditor protection for beneficiaries in high-risk professions, and the added benefit of better protection in the event a beneficiary is divorced or sued.
NOT A TAX PLAY
However, naming a trust as beneficiary of an IRA provides no income tax advantage over naming a spouse or child as outright beneficiary. A conduit trust does not hold on to any of the IRA distributions. The trust is required to send each distribution out directly to the beneficiary.
IMPLEMENTATION & MANAGEMENT
Upon the death of the IRA owner the trust is the beneficiary and becomes the new owner of the IRA. It behooves anyone contemplating this structure to find a financial institution that has experience with implementation of this strategy. It’s quite possible that the titling will change multiple times during the estate settlement process, and finding a financial institution that understands this process may be a challenge.
For example, say someone names his or her revocable trust as the beneficiary and they have three children that are the ultimate beneficiaries of the revocable trust. At their death, the process may require their revocable trust to become the owner of the IRA, and then distribute and retitle the assets again into each beneficiaries’ trust once the estate has settle. This requires administrative expertise, as it’s not a very common transaction.
RETIREMENT ENHANCEMENT AND SAVINGS ACT POTENTIAL IMPACT
It is worth mentioning, the Senate Finance Committee unanimously approved the Retirement Enhancement and Savings Act, and on Nov. 16, 2016, they placed it on the Senate Legislative Calendar. To help offset the cost of legislation, the proposed bill would essentially eliminate the Stretch IRA for non-spousal beneficiaries, requiring beneficiaries of an inherited IRA to pay all taxes due on accounts of more than $450,000 within five years of the owner’s death. If the beneficiary is disabled or chronically ill, or not more than 10 years younger than the deceased, distributions could be taken over the beneficiary’s lifetime. If the beneficiary is a minor child, such distributions must be taken within five years of reaching the age of majority.
THE STRETCH IRA ALTERNATIVE
Don’t forget that the true power of the IRA stretch comes from tax-free accumulation of assets, so if the stretch IRA is no longer going to be available, then it’s important to find alternate sources of tax-free accumulation. So, rather than leaving the IRA to non-spousal beneficiaries, the IRA owner should consider taking current withdrawals, paying income taxes on the distributions and then gifting monies to an irrevocable life insurance trust (ILIT) to purchase life insurance. The cash values inside life insurance grow on a tax-free basis, while the policy’s death benefit would be also income and estate tax-free. An ILIT could allow distributions to beneficiaries over their lifetime or a set term of years, subject to the terms of the trust, which would mirror the IRA stretch. Additionally, while inherited IRAs aren’t given the same creditor protections as traditional IRAs, an ILIT can provide creditor protection for beneficiaries.2
THE BOTTOM LINE
The benefits of a Trust Owned Inherited IRA structure are significant on the asset protection side of planning. However, a Trust Owned Inherited IRA is a complicated structure and requires a sophisticated team to put it together and make sure it’s implemented properly.
1 From information provided by the Investment Company Institute, Washington, D.C.
2 Clark v. Rameker, 573 U.S. 573 U.S. 2014.