Lions, and Tigers, and IRAs! Oh MY!

After saving for decades, many people consider their most significant asset to be their qualified retirement plan or their Individual Retirement Account (IRA). It is not uncommon for a client to come into our office and lament that they never should have invested so much into their IRA because “it’s all going to the government anyway.” Yes, it is true that qualified retirement and IRA benefits are includible in your taxable estate. And, yes, it is true that even after that estate tax hit, the beneficiaries are subject to income tax once the benefits are received. But, it is also true that every asset is counted toward the taxable estate – not just the IRA. More importantly, the initial investment was funded with pretax dollars. The full dollar was working in the market and not just a fraction of an after-tax dollar. So, sure, the benefits may be subject to estate tax if the taxable estate is over $1 million (Oregon) or $2 million (2007 federal), and ultimately included in the recipient’s taxable income, but the additional earnings generated on a pretax dollar is a significant advantage.

If the beneficiary designation is structured properly, the beneficiary can continue the income tax deferral and “stretch out” the tax savings over their own life expectancy. If the beneficiary is the surviving spouse, the spouse can actually rollover the benefits into their own IRA, and start over on an extended deferral table. But, it is critical to properly draft the beneficiary designation. For example, naming a living trust that benefits a surviving spouse as the beneficiary will not have the same tax effect or deferral opportunities as naming the spouse as an outright beneficiary.

For the philanthropic client, there is no better asset to leave to charity than the tax-deferred benefits of a qualified retirement plan or traditional IRA. This is because such a charitable bequest reduces the taxable estate dollar for dollar. In other words, there is no estate tax on the benefits. In addition, because the charity is a tax-exempt organization, there is no income tax on the benefits received by the charity. So, instead of leaving your favorite charity the real estate and the investment account, consider leaving them some of your IRA.

If you are charitably inclined and over the age of 70½, you may make a contribution of up to $100,000 directly from your IRA (but only an IRA, not a qualified retirement plan) to a charity without including the distribution in your taxable income. This only applies for the year 2007. In the past, and for all subsequent years after 2007, if a donor wants to contribute funds from an IRA to a charity, the donor must personally withdraw the funds from the IRA and then make the gift to the charity. Although the subsequent gift to charity qualifies for a charitable deduction, the withdrawal itself is a taxable event to the donor and the donor, must recognize the entire amount withdrawn as income for that taxable year.

On another retirement planning note, employer-sponsored retirement plans often require payment of benefits to a non-spouse beneficiary in a lump sum or within five years. Effective January 1, 2007, a new law permits a trustee-to-trustee rollover from the plan to the individual’s IRA, enabling the individual to defer the taxable distributions.

So dry those tears. The tax deferral and planning opportunities of your IRA may not be so bad after all. Follow these suggestions to make sure those tears don’t well up again:

Make sure you have named both primary and contingent beneficiaries on your retirement plan or IRA account. No beneficiary named on a Retirement Plan or IRA results in NO DESIGNATED BENEFICIARY. Proceeds automatically revert to the “estate,” resulting in not only a probate of the asset, but also a loss of the income tax deferral opportunities as well.
Understand that your will or trust does NOT control where your IRA passes. The beneficiary designation form controls, NOT the will or trust. The only way the will or trust can control the manner, and not necessarily the distribution rate, is if the will or trust is actually the beneficiary designated on the appropriate beneficiary designation form.
Do not name a minor outright on beneficiary designation. Naming a minor child as a direct beneficiary may result in a conservatorship for that child and the subsequent annual accountings to the probate court. It is better to name a separate trust for a child as the beneficiary as opposed to simply naming the minor child outright.
Consider naming spouse as primary beneficiary. Only a spouse can rollover the benefits and start “anew.” Non-spouse beneficiaries must start to take distributions promptly.
Consider naming a charity as beneficiary. As discussed above, use retirement or traditional IRA account assets when giving to charity. A bequest of such assets results in no estate or income taxation on such assets.
If retiring after 55 and before age 59½, do not rollover retirement account into IRA. There is a 10% penalty on distributions prior to age 59½ from qualified retirement accounts and IRAs; however, there is an exception for distributions from retirement accounts (not IRAs) following separation of service to employer after age 55.
If surviving spouse does not need the retirement or IRA assets, leave benefits to younger generation. This strategy uses the estate tax exemption and provides greater income tax deferral.
Consider Using a “Conduit Trust” if concerned about beneficiary potentially withdrawing funds prematurely. A “Conduit Trust” is a trust wherein the trustee is required to withdraw and distribute only the minimum required distribution, thereby assuring that the beneficiary will take advantage of the life expectancy payout method and greater income tax deferral.

If you have any questions about planning with your retirement benefits or IRA, or you need assistance with any of the items above, please give us a call.