How Does an IRA Fit Into Your Estate Plan?
When you think of IRAs, you probably think of retirement. But what happens to your IRA money after you’re gone? The answer depends on how you go about creating your estate plan and selecting beneficiaries, and you might be surprised to find out that your money could end up with the wrong people or cause an unexpected tax bill if you don’t take action ahead of time.
Posted on September 26, 2017
What your IRA means for your estate plan
Individual retirement accounts (IRAs) are often one of the biggest financial accounts you invest in over the course of your lifetime. When you’re working on your trust, will, and other documents contained in your estate plan, you have to consider all the “big stuff” like your IRA, your house, and your small business, to name a few. But unlike the way we may use some trusts for your family, IRAs have limited lifetime planning opportunities.
IRAs are also subject to income tax (yes - even one you inherit), even though the estate tax or death tax only applies to large estates over $5.49 million. Leaving your IRA to a spouse is a common choice, but you can’t assume that your IRA will automatically be distributed to your surviving spouse. Your spouse must be explicitly named as its beneficiary through a proper beneficiary form.
Common IRA mistakes
One of the most common mistakes people make is letting their IRA beneficiary forms become out of date after a divorce, the birth of a child or grandchild, or another major life event that would alter their choice of beneficiary.
Another misstep to avoid is naming your own estate as the beneficiary of your IRA. If you name a beneficiary such as your spouse or child, they’ll be in the position to make that money grow into even more wealth over time by using the so-called “stretch out” feature of these accounts. If your own estate is the beneficiary, the money will be passed onto your loved ones in as little as five years (and possibly even faster), resulting in greatly accelerated (and often higher) taxation and a halt to the IRA’s potential growth over time. A bad result all around.
If you decide to leave your IRA to your minor children, you can cause a less-than-ideal situation by forgetting to appoint a guardian to oversee the IRA until your kids are old enough to inherit the IRA. Without a guardian, IRAs left to underage children can end up going to exes or other people you might not wish to share your wealth with. Better than a guardian, you can create an IRA trust to receive the IRA distributions, providing long-term financial support for your children or grandchildren and protection against meddlesome exes or others you don’t want to be involved in your children’s inheritance.
IRAs and estate and income taxes
It’s important to sit down with an estate planning attorney to determine how your IRA will be taxed and plan accordingly. For those with large estates, a life insurance policy and life insurance trust could be taken out to offset the cost of those estate taxes for your beneficiary. Remember, in addition to estate taxes for those with a large estate, your IRA distribution will also trigger an income tax for your recipient, regardless of the size of your estate. Roth IRAs are an exception to the income tax for beneficiaries. Whether a Roth IRA makes sense is something you can explore with us, your tax advisor, and your financial planner. Like many legal, tax, and financial strategies there are no one-size-fits-all solutions.
Because of the estate and income taxes that occur when IRAs are passed on to beneficiaries, they’re an excellent way to include some charitable giving as part of your estate plan. If you donate your IRA value to a charity, you’ll have a charitable contribution deduction as well as the ability to bypass loss of the IRAs value through income tax. If you are interested in benefiting your church or another charitable goal, it’s always an excellent idea to bring this up with us as your estate planning attorney and with your financial advisor as well, so we can help you build a plan that lets you give back.
Turning even a modest IRA into a huge advantage for your family
One way to make the most of an inherited IRA is to take a stretch-out approach. This strategy lets your beneficiary stretch the length of time over which they’ll be collecting money from the IRA, giving it more time to accrue growth without income taxes eating away at it. When this is paired with a retirement trust, the result can be a huge, long-term inheritance for your family, even if your IRA is only a modest amount. This is just one of several ways you can work with estate planning attorneys to make sure your loved ones get the most out of your hard-earned wealth for years to come.
Even though passing your IRA to your spouse or onto the next generation may seem relatively straightforward, there are plenty of pitfalls along the way without the guidance of an expert. Get in touch today, and we’ll review your current IRA beneficiary forms to make sure everything is up to date and works to achieve your goals.
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