inherited ira

Estate planning for IRAs can be tricky

Here is a little story about an inherited ira. Uncle Ira hired us to do his estate planning. It turns out that he has a substantial amount of money in several Individual Retirement Accounts (IRAs). Estate planning for IRAs can be tricky. IRAs are different from most other assets, because whoever inherits them must pay income taxes. That’s not true with bank accounts, real estate, stocks, bonds and almost everything else – those go to the beneficiaries income-tax free.

The tricky part will be arranging Uncle Ira’s estate plan so that the beneficiaries’ income taxes are as low as possible. For example, Uncle Ira has a $100,000 bank account, and a $100,000 IRA. In his will, he says “I leave my $100,000 bank account to my favorite charity, the Friends of Left-Handed Bowlers.”   He has named you as the beneficiary of his $100,000 IRA. The FOLHB gets their $100,000 tax-free, but you get $100,000 minus the income taxes (in whatever income tax bracket you happen to be.)

Now, suppose he reversed that – left his bank account to you, and the IRA to the FOLHB. You would get your $100,000 tax free; the FOLHB would get the $100,000 IRA in their 0% tax bracket, keeping the whole $100,000. The FOLHB would be in the same position, but you would be much better off.

So, the first part of estate planning for IRAs is to make sure the IRA funds go to the beneficiaries who are in the lowest income tax bracket. (General estate planning principle: if you plan to leave anything to charity, it should come first from IRA proceeds. Sometimes, it takes a little clever will and trust drafting to make that happen.)

The second part is figuring out how to “stretch out” the distributions and taxation over the longest time. The IRS has issued regulations describing the procedure for naming a trust as the beneficiary of an IRA. If Uncle Ira’s trust does not have the “magic language,” then the IRA proceeds must be distributed (and taxed) over no more than five years. (Ouch!) But if his trust conforms with the regulations, you can “stretch out” those payments over many years, potentially saving a lot of income taxes, while getting all the benefits of a trust. (Protection from creditors, protection against disinheritance, protection against wasteful spending, etc.) Don’t worry; we’ll take care of Uncle Ira and get his estate plan set up properly.

What about you? If you have a substantial amount of money in your IRA, and you have a trust, make sure your trust conforms to the IRS regulations for maximum income tax deferral. (Hint: we can help.) To make your beneficiaries pay more income taxes than necessary would just be crazy. . . kinda’ like Uncle Ira!