Estate planning with individual retirement accounts

November 28, 2017

 

by Jason Harrel
and Wendy Morodomi

Individual Retirement Accounts (IRA) can easily cause some problems in estate planning if not dealt with correctly. Most married individuals name their spouse as the primary beneficiary of their IRA and are often told not to worry about their IRAs in their estate planning because they’ve already designated a beneficiary.

This can be a mistake.

Many of the common issues we see with decedent’s IRA accounts could have been solved by a little estate planning.

The most common problem with IRAs in estate planning is when the primary beneficiary predeceases the owner of the IRA and the owner of the IRA failed to update his or her beneficiary designations or name a contingent beneficiary to his or her original designation.

In this situation, the IRA ends up in the owner’s probate estate and is subjected to all the delays, formalities and expenses of a probate proceeding, the outcomes of which have their own varying degrees of favorability. In estate planning, we are typically trying to avoid probate.

For example, if the IRA owner reached the required beginning date (usually April 1 of the year following the year in which the IRA owner attains age 70 and one-half), then post-death distributions will be made using the IRA owner’s life expectancy in the year of death. For example, if the IRA owner died at 71 having survived the required beginning date and the IRA owner’s life expectancy was 87 years of age, but he failed to name a beneficiary, the recipient(s) of the IRA can spread the required distributions over 15 and one-half years.

If, however, the IRA owner did not designate a beneficiary and did not survive the required beginning date, the IRA must be distributed within five years. This is a horrible result because simply naming a beneficiary would allow the beneficiary to treat the IRA as an inherited IRA, and he could stretch the distribution period over the named beneficiary’s own life expectancy, as explained below.

Another problem we see quite frequently is an elderly parent that names their high-tax-bracket children as beneficiaries of a large IRA. If the parent’s estate is taxable (meaning it is more than the unified credit amount at the time of death, currently $5.4 million) then the IRA can be subject to large amounts of estate and income taxes.

For example, if the parent’s overall estate is above the unified credit amount and subject to the 40 percent estate tax and the beneficiary has a 33 percent federal income tax rate and a 10.3 percent California income tax rate, then the combined taxes on an IRA of $100,000 will be approximately $66,701 (estate tax = $40,000; CA income tax = $10,300; federal income tax = $16,401).

Although the only way to avoid heavy income taxation is to name a charity as the beneficiary, there are ways to mitigate the taxes by carefully selecting the beneficiaries.

If your children are in a high-income tax bracket, you may want to consider leaving your IRA to your grandchildren. If you do decide this is what you want to do, then you need to plan accordingly. If your grandchildren are minors, a guardian will need to be appointed by the court to collect the IRA. This may not be an ideal situation because it will require filing documents with the court and submitting accountings for the court’s approval. You can prevent this by leaving it to your grandchildren under the California Uniform Transfer to Minors Act. Keep in mind that naming your grandchildren as designated beneficiaries is advisable only if you have enough generation-skipping transfer tax exemption available (currently $5.4 million). If you have utilized your generation-skipping transfer tax exemption, the IRA would be subject to an additional 40 percent generation-skipping transfer tax.

Whether you name your children, grandchildren or other non-spouse individual as the beneficiary of your IRA, they can now make a direct rollover of an eligible retirement plan to an inherited IRA.

This is great news for non-spouse beneficiaries because the inherited IRA will be subject to withdrawal over their own life expectancy rather than the five-year rule or the deceased owner’s remaining life expectancy.

Another option for your designated beneficiary is to name a trust as the beneficiary. This can be a risky choice if not done right. Several issues must be addressed and are beyond the scope of this article. Please contact your estate planner to discuss whether or not this is a good option for you.

As such, it is extremely important to name both a primary and contingent beneficiary and to properly choose your IRA beneficiaries so that unintended results are avoided. It is also important to periodically review your IRA beneficiary designations so that they can be updated as change of circumstances warrant.

— Jason W. Harrel is a Partner at Calone & Harrel Law Group, LLP who concentrates his practice in all manners of taxation, real estate transactions, corporate, partnership and limited liability company law matters. He is a certified specialist in taxation. Mr. Harrel may be reached at (209) 952-4545 or [email protected]

— Wendy M. Morodomi is an Associate at Calone & Harrel Law Group, LLP who concentrates her practice in all manners of taxation, real estate transactions, corporate, partnership and limited liability company, estate planning, trust administration and probate law matters. She is a certified specialist in estate planning. Ms. Morodomi may be reached at (209) 952-4545 or [email protected]

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