The Problems for Children Who Inherit an IRA or QRP
The hard-earned retirement fund you accumulated over your lifetime is one of the most precious gifts you can leave to your children because such funds are probably the only asset you have that could continue to grow tax-deferred during your children’s lives. Over the years this can result in a much larger bucket of money than you left them at the time of your death and still give them some annual income.
IRAs and Qualified Retirement Plans (QRPs), such as a 401(k), are the prime assets in many estates. They are surprisingly complicated financial accounts — especially when it is time to take distributions. Few people know how to handle them. Be sure your beneficiaries have the information they need to make the right decisions.
Therefore, a major part of your estate planning should be to help your beneficiaries know what to do and what not to do with the eventual inherited IRA and/or QRP, such as a 401(k) account.
Inherited Traditional IRAs Are Taxable and Not Easy to Understand
Inherited IRAs and QRPs are more complicated than you may think. Adult children, as IRA beneficiaries, often misunderstand or don’t know some key rules. You can’t realistically expect that your children will necessarily get good advice from the IRA custodian or from any accountant or financial advisor who does not specialize in the inheritance of QRPs. Many advisors are just not up to speed on the rules, and IRA custodians are not in the business of advising beneficiaries about their best options. A wrong action or inaction by your beneficiaries will trigger higher income taxes in a shorter time frame. Depending on your child’s income tax bracket, income taxes can take up to 35% or more of an inherited IRA.
When your children inherit your IRA or QRP accounts upon your death, they are not permitted to rollover the IRA to their own IRA. If a child inherits all or a portion of the IRA and rolls it over into his or her own existing IRA, then the entire inherited IRA would be fully taxable. The child would be treated as though the inherited IRA was distributed directly to him or her in cash. The child also might owe a 6% excess contribution penalty for each year the money sits in his or her IRA. If the child rolls over the inherited IRA to a new and separate IRA in his or her own name, then the child will owe only the income taxes.
Dangers of Loss and Waste
Upon your death, many IRA custodians simply ask the beneficiaries what they want to do with the IRA account and don’t fully explain the consequences of the actions. Therefore, for most parents the real concern is that the applicable IRA or QRP plan may require a faster payout than you would want. Or, the beneficiary may choose to take a faster payout or even a lump sum distribution. A lump sum distribution requires your child to pay all the income taxes at once, and then they may be more likely than not to unwisely blow through the money that is left much faster than you might think is wise. Only you can prevent this unfortunate result.
Despite all their parents’ planning, an extremely high percentage of non-spouses who inherit IRAs simply take the balance as a lump sum and spend it quickly. That’s really too bad! They will pay income taxes on the entire balance. The amount they have left to spend will depend on their income tax brackets and your estate tax bracket. In most cases, it ends up being a fraction of the IRA’s original value.
What is the reasonable alternative?
Instead of spending the IRA on whatever their current needs are, beneficiaries should let the IRA continue to grow and compound tax deferred. In many cases, especially if your IRA account is more than $150,000, they should just take the annual “minimum required distribution” (an annual “paycheck”) over their own life expectancies. This is called a “stretchout.” (The MRDs have to begin by Dec. 31 of the year following the year of the previous owner’s death.)
As a result, they would end up over time with significantly more wealth compared to taking the entire lump sum IRA distribution. (If they need cash, it probably even makes more sense for the heirs to suspend their own 401(k) and IRA contributions, or other savings, for a while to free their own cash instead of taking distributions from the parent’s IRA, which is usually a significantly larger account.)
Furthermore, to prevent immediate taxation, an inherited IRA must not only be maintained, but also it must be retitled by September 30 of the year after the year of the original owner’s death. The new title must have the name of the deceased followed by “deceased” or “decedent.” Also included must be the beneficiary’s name and statements that the account is “for the benefit of” or “FBO” the beneficiary, and that it still is an IRA. For example: “Max Profits, deceased, IRA FBO Hi Profits, beneficiary.”
No Asset Protection
A surprising fact is that even though your retirement funds have some “asset protection” while you’re alive, the same isn’t true for your inheriting children because retirement accounts can be seized once they pass to your loved one.
Under a recent U.S. Supreme Court ruling, inherited IRAs are generally not protected from bankruptcy creditors.
Furthermore, as you know, about 50% of all married couples end up in divorce. As a result, your children’s divorcing spouse may end up seizing 50% or more of your child’s inherited IRA funds. Wow!
The Best Solution
What Is The Big Deal?
Your IRA Account Can Grow Much Larger Over Time For the Benefit of Your Heirs.
Despite the apparent goal of the “minimum required distribution” rules (assuring tax-favored retirement plans are used primarily to provide retirement income), § 409(a)(9) of the Internal Revenue Code permits the retirement account to stay in existence long past the death of the participant whose work created the benefit—if the participant leaves his retirement benefits to the right kind of beneficiary, called a “Designated Beneficiary.”
As of 2002, an inherited IRA can now be split into separate IRAs for each of the beneficiaries. Then, each beneficiary makes individual investment decisions and takes RMDs (annual paycheck) based on his or her own life expectancy. However, if splitting an IRA is what your beneficiaries are likely to do, then you must check with your IRA custodian. Even though the tax law allows IRAs to be split, the custodian doesn’t have to allow it. Be sure the custodian will allow a split and will not charge fees or penalties for the split. If it won’t, consider moving the IRA to another custodian now.
Depending on investment returns, if the beneficiary is young, and takes no more than the MRD each year, the value of the inherited plan can soar under the life expectancy payout method by the time the beneficiary reaches retirement age.
For example, a 38 year-old beneficiary who inherits a $500,000 traditional IRA and withdraws it using the life expectancy method will have $1,696,000 inside the IRA, plus $1,432,000 outside the IRA in 30 years. If he cashes out the entire amount when he inherits it, he will have (outside the IRA) only $1,470,000—assuming he doesn’t spend the entire $500,000 over a relatively short period of time. (This example assumes an 8% constant investment return for all assets and a 36% tax rate on all plan distributions and outside investment income.)
Why Is A Standalone Retirement Trust the Best for Your Heirs?
The best option for protecting retirement accounts is to create a Standalone Retirement Trust (SRT). The SRT has major benefits because it:
- Ensures retirement accounts will go to whom you want-and nobody else. The inherited IRA funds remain in the family bloodline and out of the hands of your child’s spouse or ex-spouse.
- Prevents beneficiaries from wasteful and reckless spending on frivolities and blowing the funds in a short time on fancy vacations, jewelry, expensive cars, etc. (These are things you often didn’t do or buy in order to build up the retirement account.)
- Allows the IRA account to continue to grow much larger while being tax-deferred. As a result, it can fund your children’s own retirements many years down the road while providing them an annual “paycheck” too.
- Allows the funds to be paid over time (“stretchout”) based on each child’s own life expectancy, which makes the amount of each RMD smaller.
- Protects inherited retirement accounts from beneficiaries’ creditors, as well as “predators” (divorcing or money hungry spouses).
- Allows for experienced management of the funds by a professional or bank trustee.
- Permits you to name minor (under 18) beneficiaries without court-supervised guardianship.
- Enables proper planning for a special needs beneficiary.
- Facilitates generation-skipping transfer tax planning if federal estate taxes are applicable.
Continued Investing of the Funds in an IRA or QRP
The ability to invest funds without current income taxation of the investment profits is one of the most valuable features of traditional tax-favored retirement plans.
Investing through a QRP often defers income tax not only on the investment profits, but also on the owner/retiree’s (“participant”) compensation income that was originally contributed to the plan. The longer this deferral continues the better because the deferral of income tax generally increases the ultimate value of the benefits.
As long as assets stay in the plan, the participant (you) or designated beneficiary, if applicable, is investing not just “his or her own” money, but also “the federal government’s share” of the participant’s compensation and the plan’s investment profits—that is, the money that otherwise would have been paid to the IRS (and will eventually be paid to the IRS) in income taxes. This may be your only opportunity to invest the government’s share of anything!
Retaining the money in the retirement plan enables the participant or beneficiary to reap a profit from investing “the IRS’s money” along with his or her own. Once any funds are distributed from the plan, they are included in the gross income of the participant or beneficiary, who then pays the IRS its share, based on the applicable income tax rates. Thereafter, the participant or beneficiary will no longer enjoy any investment profits from the government’s share of the plan.
Long-term deferral of distributions also tends to produce financial gain within a Roth IRA retirement plan, even though income tax is not being deferred because the funds placed in the Roth IRA were after-tax dollars.
What Can Happen to Your IRA Without A Standalone Retirement Trust?
The Real Problem
Without a SRT, the real concern for most people is that the applicable IRA or QRP plan may require a faster payout than you might want. Or, the beneficiary may simply choose to take a faster payout or even a lump sum distribution. A lump sum distribution requires your child to pay all the income taxes at once, and then they may be more likely than not to unwisely blow through the money that is left much faster than you might think is wise. Only you can prevent this unfortunate result!
“Life Expectancy” or “5-Year Rule”: Which Applies?
When a participant/owner/retiree dies before his RBD [“Required Beginning Date”], the life expectancy method may apply if the participant left his benefits to a Designated Beneficiary.
Under the regulations, the Plan [IRA Plan or QRP with a Custodian] can permit the Designated Beneficiary of a participant who died before his or her RBD to choose between the “5-Year Rule” and the “Life Expectancy Payout Method.” Reg. §1.401(a)(9)-3, A-1.
Under the “5-Year Rule” no annual minimum required distributions are required. The only requirement is that the entire plan balance must be distributed by December 31 of the year that contains the fifth anniversary of the participant’s death. There are other special rules and regulations if the participant died on or after the RBDs began.
If the participant dies on or before his RBD leaving the benefits to a child or children as the Designated Beneficiaries, then each beneficiary’s life expectancy or the participant’s life expectancy, whichever is longer, probably will be used unless the plan requires otherwise.
Of course, even the best laid plans of a future beneficiary “never to touch” the inherited retirement account can go astray. The RMD of an inherited IRA or retirement plan actually begins as a very small percentage, but just a little bit extra taken from time-to-time can significantly impact and lessen the accumulation and tax deferral power.
These rules are very complex, and a CPA or tax attorney should be consulted before any action is initially taken.
Action you must take now
An important key to remember is that a retirement “plan” (with a custodian’s company) is not required to offer all the payout options that the law allows. For example, when the 5-Year Rule applies, a plan is not even required to allow the Designated Beneficiary to spread out the distributions over the 5 years.
While most IRA plans permit the “life expectancy” payout method, the situation may be just the opposite with QRPs. Most QRPs only offer death benefits in the form of “lump sum payments” or “lump sum distributions.”
Therefore, before signing any “Beneficiary Designation Form” you should find out from your plan custodian the answers to the following questions:
- “Does the Plan allow the splitting of the IRA into separate accounts, one for each of your beneficiaries?” Even though the tax law allows IRAs to be split, the custodian doesn’t have to allow it. Be sure the custodian will allow a split and will not charge fees or penalties for the split.
- “Does the Plan provide that even if benefits are left to a Designated Beneficiary (DB), the “5-Year Rule” applies to some or all situations, with no option for the Designated Beneficiary to elect a life expectancy payout?” (If the plan has this rule and it applies to this beneficiary, then the plan provision controls.)
- “Does the retirement plan allow a Designated Beneficiary to elect between the 5-Year Rule and the Life Expectancy Payout Method? And, “Does the election become irrevocable by the deadline for making the election?”
- “Does the plan provide a default rule, under which the life expectancy method or the 5-Year Rule will automatically apply if the DB fails to elect one method or the other by the applicable deadline?” “If the plan does not provide a default rule, does the plan provide that the life expectancy method will be used for the DB?” “If not, does it provide that the the 5-Year Rule will be used for the DB?”
- “Does the plan require a faster payout or lump sum payout?”
- “Under the plan, can the designated beneficiary choose to take a faster payout or a lump sum payout?”
Types of Qualified Retirement Plans:
- “Defined Contribution Plan” and “Defined Benefit Plan” are the two broad categories of QRPs (Qualified Retirement Plans). A “Defined Contribution Plan” also is called “individual account plans.”
- Individual Retirement Account (IRA): An IRA is a private, one-person retirement account that is created under, and given special tax benefits, by § 408 of the Internal Revenue Code (“Traditional IRA” or “Roth IRA”) An IRA account can be structured either as a “custodial account” (most common) or as a trust (in which case it may be called an “Individual Retirement Trust” or a “Trusteed IRA”). If an IRA is funded by directed contributions from the participant’s employer, it is a “SEP” or “SIMPLE.” (Check with Advisor.)
- § 401(k) Plan: A non-government employer can offer 401(k) plans to employees. Each employee in the plan determines how much money is to be automatically contributed from each paycheck on a “pre-tax” basis, meaning the savings are taxed only when later withdrawn from the account. Workers have a say in how the plan administrator invests their savings. Employers also may choose to contribute to each employee’s plan. Roth investments use after-tax dollars and are not taxed when later withdrawn. (Check with Advisor.)
- § 403(b) Plan: A retirement plan used by tax-exempt organizations, which can be employees of public schools and other organizations. Many are invested in “Deferred Annuities” or “Tax Sheltered Annuities.” These are a type of annuity contract provided by insurance companies, and they are invested to provide income later in life. (Check with Advisor.)
- ESOP (Employee Stock Ownership Plan”): This is a QRP primarily designed to invest in stock of the sponsoring employer. (Check with Advisor.)
- KEOGH Plan: A Keogh plan (called an H.R.10 Plan) is a QRP that covers one or more self-employed individuals. Thus a Keogh plan is a QRP established by an unincorporated employer (partnership or sole proprietor) for the benefit of the partners and employees of the partnership, or for the benefit of the sole proprietor (and his employees, if any.) (Check with Advisor.)
I sincerely hope this general educational article has been of value to you.
Important Notice: Please understand that this document is intended only to provide basic and general information. IRS Codes and Regulations are very complex with many twists and turns, and the advise of a CPA should be obtained. The information contained herein should not be acted upon without professional legal advice related to your specific situation, circumstances, goals and needs. The information in this document is not intended to provide any legal advice to you or anyone else and cannot create an attorney-client relationship between you and Carlson Law Office, LLC. You should always seek legal advice about your situation in the context of an attorney-client relationship. No representations or warranties, express or implied, are made.
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