Qualified retirement plans are designed to encourage people to save for retirement. The most common retirement plans are individual retirement accounts (IRAs) or employer-sponsored plans such as 401(k)s or 403(b)s.
Typically, individuals receive an income tax deduction for contributions made to a traditional IRA and the investments inside these accounts grow tax-deferred until they’re distributed. However, there’s a 10% penalty if withdrawals are made before age 59½ and a 50% penalty after age 70½ if the required minimum distributions (RMDs) are not taken out. These rules encourage retirement planning savings, but discourage generational wealth planning by using RMDs to force the money out of retirement plans during the account owner’s life.
Federal ERISA laws for employer-based plans and federal and state laws for individual qualified retirement plans provide partial or full exemption from bankruptcy proceedings. These laws and regulations, however, don’t say whether accounts inherited after the death of the IRA owner (or an “inherited IRA”) are exempt from bankruptcy proceedings. Proper planning can help ensure after-death income tax deferral and protect inherited IRAs from creditors.
Although the IRS discourages IRA accumulations during life by setting strict penalties for violations of the RMD rules, the IRS established something called the Uniform Table in 2002 to ensure no one would outlive their IRA. The Uniform Table helps determine how fast IRA asset should be distributed during an account owner’s life. An IRA owner is not required to take out any more than the RMD, but if they take out only the RMDs during their lifetime, there may be money still in the IRA after death.
So what happens to an IRA after the account owner’s death? That depends on who is named as the beneficiary and how old the owner was at his or her death. A surviving spouse is the only beneficiary who can roll over a decedent’s IRA into their own, and in most cases, they will. As a result, any RMDs are now based on the surviving spouse’s life expectancy. There are exceptions for a surviving spouse, but for the most part, surviving spouses will typically roll over the IRA assets.
When a non-spouse is named a beneficiary, the rules are clear: they can’t roll over the deceased owner’s IRA into their own IRA. However, a non-spouse beneficiary is not required to immediately liquidate the decedent’s IRA. IRS rules do say that the non-spouse beneficiary must take out RMDs based on two factors: his or her age and whether the IRA owner died before or after age 70½. Ideally, an IRA owner names a trust as the designated beneficiary. That gives the trust’s beneficiaries creditor protections and protections from divorce proceedings, as well. However, there are specific rules to follow when naming a trust as a beneficiary.
Those worried about shoving money into the pockets of young children or grandchildren, but still looking to protect assets left to adult children from creditors, divorces or bankruptcies can do this by naming a trust as the beneficiary of the IRA. While some lawyers worry that the IRS might not deem a trust as a designated beneficiary, regulations do allow it. That means the beneficiary’s life expectancy will be used to determine RMDs, as long as the trust satisfies five rules:
- The trust must be valid under state law;
- It must be irrevocable at the death of the IRA owner;
- The beneficiaries must be identifiable in the trust;
- All trust beneficiaries must be individuals; and
- The trust or trustee certificate identifying all beneficiaries is delivered to the plan administrator.
The safest plan is for an estate planning attorney to create separate IRA trusts for younger beneficiaries to ensure their life expectancies will be used to determine RMDs. The person creating the estate plan must work with their plan administrator to ensure they’ve accepted the customized beneficiary designation naming the trust. That helps ensure the administrator will send the IRA to the trusts without triggering a distribution from the IRA, a taxable event.
Even though naming trusts and a designated beneficiary is recognized and allowed by the IRS, issues, delays and disputes can arise after death if the plan administrator, custodian or financial institution will not or does not know how to properly distribute the inherited IRA into a trust. That’s a far more common occurrence than you might think!
Inherited IRA planning can be a very effective tool in passing wealth down to your kids or grandkids. However, you’ll want to work with an experienced estate planning attorney to ensure everything is done properly.
For more information on this and other estate planning topics, explore our website and contact us to schedule your consultation today!
Reference: Elder Law Report (Jan 2017, Vol. 28, Issue 6) “IRA Trusts as Creditor Protection and Wealth Accumulation Vehicles”