Have You Considered an IRA Trust?
By John Marold
Spring 2008
For most people, the weeks leading up to April 15 are a time for intense record gathering and seeking out any steps that can be taken to optimize tax credits and deductions. In addition to focusing on actions related to the current tax year, I also recommend to clients that this is an ideal time to review the status of beneficiary designations in established IRAs and possibly consider creating an IRA trust. In the process, you may be saving yourself – and certainly your beneficiaries – a hefty tax burden.
Retirement assets in the United States reached a record total of $16.4 trillion in 2006. According to the Investment Company Institute, almost 40 percent of all American household financial assets are retirement-related, such as individual retirement accounts (IRA), employer-sponsored 401(k)s, 457(b)s and 403(b)s. For many Americans, qualified plans and IRAs represent the largest part of their estates which, in some cases, surpasses the value of their homes.
First, the bad news. At death, distribution of retirement plan proceeds to a beneficiary results in sobering tax consequences since every dollar received is subject to ordinary income taxation. For example, if a child-beneficiary inherits a $500,000 traditional IRA account from a parent and elects (or is forced into) a “lump sum” distribution, income taxes can reduce the value of that IRA by as much as 33%. Moreover, if estate taxes are applied to the IRA, the plan’s value could be reduced by 50% or more!
Now, for the good news. There are ways to avoid this. If the retirement plan allows, the beneficiary can elect to receive “minimum distributions” over his/her lifetime. This option defers payment of the income tax on amounts yet to be received. Most important, the principal remaining inside the inherited retirement account continues to enjoy tax-deferred growth over the child’s life expectancy.
So, as the child grows older, the minimum distributions from the inherited retirement account will grow in size and possibly provide the child with a lifetime of extra income (aka “stretch out”). How can you ensure that this will happen with your retirement plan proceeds?
• Contact your BB&T Wealth Advocate or employee benefits director. Ask for a review of your beneficiary designations for each of your retirement accounts to make sure they represent your best interests. If one or more do not, then fill out a beneficiary designation form to make the required changes.
• Updating beneficiary designations is absolutely critical. For example, if a parent dies before the age of 70½ with no beneficiary on his/her retirement plan, or if the beneficiary is “my estate,” only five-year or outright distribution options may be available to an heir.
What’s worse, the plan will be unnecessarily subjected to probate, and the heir may lose the option to “stretch out” the distributions over his/her lifetime. Your advocate or employee benefits director can tell you whether the retirement plan has this “stretch out” option.
• If the retirement plan is not “stretch friendly” (not uncommon with many employer-sponsored plans), then your advocate can find a more suitable plan, one that includes this feature among others. For example, most 401(k) plans are not “stretch friendly.” Many employers do not want to manage the retirement account after the employee’s death.
As a result, the employer forces the beneficiary to take an outright “lump sum” distribution, resulting in substantial reductions in the account’s value due to taxes. If the stretch option is important to you, in most cases your BB&T Wealth advocate may be able to facilitate a tax-free transfer from the 401(k) plan to a “stretch friendly” BB&T IRA.
Creating an IRA trust is another option that may appeal to you. There are many reasons for leaving your retirement plan assets in trust rather than bequeathing them outright. These include protecting the benefits from creditors and predators, providing control over their distribution to named beneficiaries by a responsible trustee, and codifying multigenerational planning features. Most important, the trust provides greater assurance of long-term growth and tax deferral over the life expectancy of each beneficiary.
Sound good? Well then, how does an IRA trust work? An IRA trust document is prepared by an attorney, and the trust is named a beneficiary of the retirement plan. To ensure long-term tax deferral, the trustee who executes the trust’s terms is provided written instructions within the trust instrument directing only required minimum distributions from the retirement plan to be passed along to the beneficiary.
If your beneficiary dies before her/his share is entirely distributed, that remaining share can then be passed down in trust to the generation below. Under the guidance of an experienced trustee or trust company, an IRA Trust can ensure a lifetime of income and superior wealth-building opportunities for each beneficiary.
An often-quoted commercial message states, “You can pay me now or pay me later.” Well, IF your retirement accounts allow for it, paying the tax man later over extended periods rather than upfront can lead to some very satisfying wealth accumulation and distribution outcomes. With careful advanced planning, you can meet your retirement goals while saving taxes for beneficiaries.
About the Author:
John Marold is an IRA Manager & Estate Planning Counsel.
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