IRAs & Estate Planning: How to Avoid the Most Common Pitfalls

February 2, 2016


IRAs & Estate Planning: How to Avoid the Most Common Pitfalls

Individual Retirement Accounts are one of the great innovations of our age, providing tax incentives for people to save money to supplement their Social Security and any pension benefits. At the same time they’re among the most bewildering of asset-bearing accounts to work into a sound estate plan, and it’s impossible to cover all the considerations in a short article. Instead, what we intend to do here is to introduce investors to the issues by helping them to avoid some of the most common mistakes people make when they’ve got IRA assets to pass on or receive.

The goal, of course, is two-fold: to minimize the loss of assets to taxes and penalties, and to preserve tax-advantaged growth status for as long as possible. Keep in mind, however, that regardless of whether they’re housed in a Traditional or Roth IRA, IRA assets are subject federal estate tax law (depending on the size of your estate); state inheritance taxes (depending on the state); federal and state income taxes and potential penalties payable by beneficiaries. Given the state of current tax law – and that is always subject to change – here’s how you and your beneficiaries can avoid the worst:

IRA Planning Tips

Never name your estate as the beneficiary. When distributed as part of your estate, IRA assets – whether in a Traditional or Roth IRA – must be fully paid out within five years, after which they no longer receive the benefit of tax-advantaged growth. In addition, while Roth IRA distributions are income tax-free, those from Traditional IRAs are fully taxable, and the size of the distributions could push the beneficiaries into a higher tax bracket.

Complete and keep copies of your custodian’s beneficiary designation forms. The default rules of the firm that maintains your IRA account take precedence over a will, so you must declare who your beneficiaries are on their own form. Beneficiaries are typically a spouse, children, grandchildren, other relatives or a charity. In addition to a primary beneficiary, name contingent beneficiaries as well.

If you don’t complete a beneficiary form, your IRA assets might revert to your estate and be subject to probate, which can delay the receipt of funds and be contested, in addition to the premature end of tax-free growth. It’s also important to keep the forms up to date as your intentions or potential beneficiaries may change, and to keep your own copies.

Inform non-spousal heirs that estate taxes can be declared as tax deductions. Spouses can roll over IRA assets into their own IRA. This is not the case for anybody else, your kids, grandkids included; regardless of whether in a Traditional or a Roth, for all of them IRA assets are considered part of your estate for federal estate tax purposes. In 2016, the estate exemption maxes out at $5.45 million per person (double for spouses). Above that amount Uncle Sam will have to be paid by the estate, with the top rate being 40%, some of which will be attributed to IRA assets. However, even though the tax payments didn’t come out of their pockets, heirs of those assets can claim pro-rated estate taxes as a miscellaneous deduction on their personal income tax returns, up to the maximum of the assets they received.

Spell out the alternatives for a surviving spouse. Surviving spouses who are the sole beneficiary of their partner’s IRA have several options, each with different consequences:

• Retain the IRA account in the deceased spouse’s name. This enables the surviving spouse to begin taking distributions from a Traditional IRA tax- and penalty-free, even if he or she is below the age of 59 ½. Alternatively, the survivor can delay taking distributions until the later of when he or she reaches age 70 ½, or the deceased spouse would have reached that age. If the distributions are in a Roth IRA, distributions are tax-free as long as the account is at least five years old, and there are no minimum required distributions. In all cases, the assets can continue to grow tax-deferred, but are subject to the inherited beneficiary designations.

• Roll the assets into a new or existing IRA in his or her name. This allows the survivor to name his or her own beneficiaries, but doesn’t allow a spouse who is under the age of 59 ½ to access the assets without incurring the 10% penalty for early withdrawals. This option also enables the survivor to take a lump sum distribution, which would be a significant taxable event and forsake tax-deferred growth of the remaining assets.

• Disclaim the benefits. A surviving spouse can refuse to receive the IRA, in which case it reverts to any other primary or contingent beneficiaries. This can be a smart estate planning choice if the survivor doesn’t need the assets and wants to minimize the size of his or her own estate when she dies.

Instruct beneficiaries to be mindful of your minimum required distributions. If you have a Traditional IRA, your beneficiaries must be sure that in the year you die they take a minimum required distribution if you hadn’t. Failure to make it could subject them to a penalty of 50% of the withdrawal amount.

Weigh carefully whether to convert a Traditional IRA to a Roth. As an estate planning vehicle, Roth IRAs are better for heirs than Traditional IRAs. While neither avoids consideration for so-called “death taxes,” distributions from Roth IRAs are always free of income taxes (as long as the account is at least five years old). But conversion from a Traditional to a Roth IRA is a taxable event, and you have to weigh the value of the advantages against the income taxes you’ll owe.

Inform non-spousal beneficiaries how to avoid income taxes and a penalty on your IRA. Children and grandchildren don’t have the choice your spouse has of a tax-free rollover of your Traditional IRA into one in their own names. Doing so would be considered the same as taking a complete lump-sum distribution, and they might also be subject to a 6% penalty for an excess contribution.

For maximum tax advantages, non-spousal heirs should retitle your IRA, adding to yours the words “Deceased, For the Benefit of [Their Name], Beneficiary”. Doing this by September 30 of the calendar year after your death retains the tax-deferred status of the assets and their growth, and extends required distributions to a schedule based on their age. Failure to do this means all the assets must be distributed over five years, and losing their opportunity for tax-deferred growth.

These are not the only estate planning considerations for IRAs. Regardless of the size of your IRA accounts, it’s in your best interest to your review your estate plan at least once a year to be sure your IRAs deliver the maximum benefit to your heirs.