Estate Planning with IRAs

Estate planning attorney Patrick Gibbs warns, “Be careful out there.”

Whenever I meet with an estate planning client, before I get into the process of what should go into the client’s will, I want to go over some of the most important “non-probate” assets my client has: the retirement accounts. The beneficiary designations (primary and secondary) for IRA’s and 401(K) accounts often control 40% or more of the family wealth. Together with choices for life insurance beneficiaries, these issues are as important as what goes into the last will and testament and/or revocable trust.

Who should be the beneficiary of retirement accounts is obviously going to depend upon the particular circumstances, so I am going to focus on some considerations in making those choices and a few mistakes a person can make in the process.

First, a married person usually has it easy for the primary beneficiary. The surviving spouse is the obvious choice. The tax laws provide that a surviving spouse can “roll over” the deceased spouse’s IRA. A surviving spouse is the only person who can do a rollover after the death of the account holder. This will usually be a smart move, but if the surviving spouse is under 59 years of age, he or she better realize that any withdrawals from that IRA will usually incur a “penalty” in the form of an excise tax. So, if there are cash flow issues for such a younger surviving spouse, that rollover IRA may not be part of the solution.

What if there is no surviving spouse? Then the secondary beneficiary designation becomes crucial. If there is no natural person named as secondary beneficiary, then the account must be distributed to the legal entity designated. If it’s a tax exempt charity, there should be no problem because the distribution will not generate any tax liability. If the secondary beneficiary is blank or the account holder’s “estate,” the personal representative of his or her estate will most likely distribute the account in accordance with the decedent’s will or the law of inheritance in the absence of a will.

That could create a very large tax bill if the account is substantial because the recipient(s) will normally be required to empty the account by the end of the fifth year after the year of the death of the account holder by taking taxable distributions (assuming it’s not a Roth IRA or 401(k)).

Upon the death of an account holder when no spouse is doing a rollover, the account becomes an “inherited IRA” subject to rules setting the required minimum distribution(s) (RMD) that must be started sometime during the year following the year of the death and continued each year thereafter. The amount of the RMD is calculated by using the life expectancy of the beneficiary on his or her birthday in the relevant year and the balance of the account on December 31st of the year of death or (if applicable) each year thereafter.

For example, assume someone with a 50 year life expectancy on his birthday in the year after the death has an inherited IRA of $300,000 on December 31st of the year of death. Therefore $6,000 must be distributed in that first year. Each year thereafter the life expectancy changes and the year-end balance must be ascertained. For a younger beneficiary with a good investment return, this “stretch-out” of the inherited IRA can multiply that account many times before he or she retires.

Hopefully, that fairly technical discussion of the rules has spotlighted some of the pitfalls for the account holder in making beneficiary designations. A few more: an old beneficiary designation that names a previous (divorced or deceased) spouse will be bad news to a subsequent spouse who assumes it can be rolled over after the death of the account holder; or a beneficiary designation of minor children as primary or secondary beneficiaries.

When the primary beneficiary does not survive the account holder, the secondary beneficiary becomes crucial and it should be someone who is not a minor or otherwise legally incapacitated. When it’s a minor, either a carefully drafted trust should be the beneficiary or a person named as custodian under the Georgia Transfers to Minors Act. The latter technique will delay the minor’s control of the account only until he or she is 18 years of age. A complicated situation, such as a permanently handicapped child or a disabled spouse, will also warrant creation of a trust that can qualify for the stretch-out based on the age of the trust’s beneficiary.

As the precinct sergeant in the TV series Hill Street Blues used to say at the end of the morning briefing for officers going out on the mean streets of New York City, “Be careful out there.”

Patrick Gibbs
Patrick J. Gibbs, P.C. Attorney at Law

Patrick J. Gibbs practices law in Roswell with a concentration on Wills, Trusts and Estates.

This article is intended to be educational. Legal advice should be obtained as to individual needs before taking any action. This article is not intended to provide any advice as to tax issues that might be relied upon by the reader in addressing his or her tax matters.