Today’s complex rules governing IRA agreements may impact your distribution options and estate tax requirements. In developing your retirement strategy, it is crucial that you and your advisor review the terms of your plan(s), especially your beneficiary-designation election. It is crucial to take the time to meet with your attorney and financial advisors to discuss how your choice of beneficiaries will fit into your overall estate plan. Through proper planning, you can ensure the maximum flexibility for yourself and, more importantly, your heirs—allowing them to stretch out the distributions and associated taxes over their lifetimes. Careful planning will help to ensure that you avoid the eight most common planning mistakes.
Not planning for the impact of estate taxes and income taxes.
Under the tax code, IRA assets are classified as “income in respect of a decedent.” As such, they do not get a step-up in basis at death. Thus, IRA assets are subject not only to estate taxes but also to income taxes. With proper planning, the income taxes can be spread over the life of the beneficiaries, but, unless the IRA is bequeathed to charity, the taxes must eventually be paid. One of the best ways to offset the taxes that will occur after death is to take a portion of the income (i.e., 1-3 percent) from the IRA to purchase a life insurance policy on the IRA owner or the owner and his or her spouse (survivorship policy) to cover the taxes.
Not being aware that estate taxes on the amount of the decedent’s IRA are deductible from the beneficiary’s income taxes.
Under Section 691(c) of the Internal Revenue Code, the beneficiary of an IRA can deduct the estate taxes that were attributable to the decedent-owner’s IRA from his or her income tax return. The deduction is available until used up, starting with the first distribution. This deduction often neutralizes income taxes on the minimum distributions taken by the beneficiary in the first few years after the death of the IRA owner. This is often overlooked by beneficiaries who end up unknowingly paying nearly 80 percent in combined taxes on IRA distributions.
Failing to name a beneficiary of your IRA.
Failing to name a beneficiary often means your estate becomes the beneficiary. It also means your IRA must either be distributed under the 5-year rule—if you die before your required beginning date (RBD), or over your remaining life expectancy under the IRS single life expectancy table based on your age in the year of your death (using the fixed-term method)—if you die after your RBD.
Not utilizing a custom beneficiary designation form.
IRAs are governed by a beneficiary designation form, not by your will. The form is filled out when the account is set up; IRA owners rarely have a copy of the form and it is not unusual to find that even the original has disappeared. A custom beneficiary designation form designed by your attorney will not only help you and your IRA custodian avoid misplacing information regarding your choices but will also help ensure that your IRA goes to the correct beneficiaries in the amounts and way you intend. Furthermore, a properly drafted beneficiary designation form will provide for alternative beneficiaries (i.e., grandchild) in the event one of the primary beneficiaries disclaims their share of the IRA.
Naming several beneficiaries to a single IRA account.
This could cause the youngest beneficiary to take out his or her share more rapidly than necessary. This is because the calculation that determines the required minimum distribution schedule for all the beneficiaries is based on the age of the oldest beneficiary. If one of the beneficiaries is a charity, the problem is worse. Because a charity has no life expectancy, the IRA must be emptied either under the 5-year rule—if death of the owner occurs before the owner’s RBD—or over the owner’s remaining life expectancy under the IRS single life expectancy table based on the owner’s age in the year of death (using the fixed-term method)—if the owner dies after his or her RBD. The best strategy is to divide the IRA into different accounts and name one beneficiary for each account. Alternatively, the beneficiaries will have a chance to divide the IRA into individual accounts for each beneficiary if it is done by September 30 of the year following the owner’s death—a step that can be easily overlooked.
Rolling out money from a qualified retirement plan to an IRA without getting a spouse’s written consent.
In certain qualified retirement plans, such as a defined benefit plan, if the plan participant is married and rolls out more than $5,000 from his or her plan, the law requires that the owner have spousal consent to do so. Without a signed spousal consent form, the entire distribution will be taxable.
Naming a trust as beneficiary without knowing all the consequences.
Most trusts qualify as beneficiaries of an IRA. However, several pitfalls await those who do not understand certain rules. For example, the IRA minimum distribution rules override trust rules, so, if an IRA doesn’t pay its required distribution to the trust (as beneficiary) every year, a 50 percent penalty (of the underpayment) is imposed. Also, if a trust receives the full minimum distribution from an IRA but does not pay it out to the beneficiaries because of a limitation in the trust, the payment will be subject to the much higher trust tax rates.
Failing to coordinate IRA withdrawals with Social Security benefits.
To maximize retirement income, it often makes sense to delay Social Security benefits until age 70 and draw from an IRA at retirement, if earlier. This accomplishes two things: it reduces the size of the IRA and it allows the retiree to receive a guaranteed 8 percent increase in their Social Security Benefits. This strategy could yield substantially more in retirement and is especially attractive when there is a younger spouse in good health.
