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Estate Planning for Traditional IRAs

Most people today have an IRA, and sometimes more than one. IRA’s and 401(k)’s and other qualified plan assets have become more popular, taking the place of more traditional pension plans. Whether an employer makes any contributions, or not, people are increasingly aware of their own need to put money aside for retirement into pre-tax vehicles like these.

The Internal Revenue Code encourages this type of retirement saving by offering income tax advantages. Funds can be diverted into these vehicles directly from an employer or from an employee’s paycheck, and no income tax is paid on those funds when they are contributed to the IRA, 401(k), etc. As those assets grow in value from year to year, no income taxes are due or payable as long as the assets remain in the IRA or qualified plan.

That doesn’t mean that no income tax will ever paid on those assets, however. The income tax liability remains and will be triggered in the future when the funds are liquidated.

Anyone who is thinking about their estate planning needs to understand the income tax consequences of IRAs and qualified plans in order to make appropriate decisions about how to incorporate them into that planning. Those income tax liabilities are only deferred at the present time, and the accrued income tax liability will be triggered down the road when you or your loved one begins to access those funds in the future.

How should we address these assets, then, knowing that the accrued, but unpaid, income tax liability lies in wait for our loved ones to whom we may leave these assets?

As a general proposition, pre-tax assets like standard IRA’s should be left to individuals, rather than trusts. We leave them to individuals by naming individuals as the beneficiaries. For a married person, your spouse will be your primary beneficiary (unless he/she waives off, and you name someone else). For this reason, we are usually more concerned about the secondary, or contingent, beneficiaries when doing estate planning.

The reason that IRA’s and qualified plan assets are, generally, left to individuals is that individuals can opt to roll over an inherited IRA/qualified plan into their own IRA and stretch out the income tax liability deferral into the future.

Note, however, that the individual must exercise that option. The individual could also choose not to exercise that option, in which case the IRA/qualified plan will be liquidated, triggering the immediate application of that deferred income tax liability.

Typical trusts don’t allow the rollover option.[i] If a typical trust is the beneficiary of an IRA, the IRA will be liquidated without the option for rollover. The funds will be distributed into the trust, and all the accrued, but previously unpaid, income tax will have to be paid for the year in which the IRA is liquidated.

Because pre-tax assets that are left to a typical trust will have to be liquidated upon death (with no rollover option), conventional wisdom suggests that individuals should be named as beneficiaries, rather than trusts. That doesn’t mean, however, that naming a trust as beneficiary is never advised.

Naming a trust as the beneficiary of an IRA may be the best choice under certain circumstances. Circumstances in which naming the trust might make sense, rather than an individual, include, but are not necessarily limited to, the following:

  • When desiring to leave the asset to beneficiaries who are minors;
  • When desiring to leave assets to/for a person with special needs;
  • When the funds are likely to be needed immediately (like for college); or
  • When desiring to leave the asset to beneficiaries who might not opt to rollover.

Under the last circumstance, the issue becomes whether there is any need to protect or control the asset for or from the beneficiaries. If the individual to whom you are leaving the assets is likely to choose to take an immediate distribution of the funds (triggering the income tax obligation), you might as well leave it to that beneficiary in a trust where the assets will be protected from creditors as long as they remain in the trust. If you have concerns about the individual’s lack of maturity, spendthrift tendencies, lack of understanding, addictions or any number of issues, you are better off making your trust the beneficiary where access to the funds in the trust can be limited for the protection of the beneficiary.

If you name an individual as direct beneficiary of an IRA, that individual may liquidate the IRA, immediately triggering the income tax obligations, and the funds in the hands of the individual will be without any controls or safeguards.

If, for whatever reason, the IRA is likely to be liquidated by the individual(s) you name as beneficiaries, then you may better off naming the Trust for any of the following reasons:

  • The trust provides creditor protection;
  • You can control the funds in the trust for the protection of  the beneficiary from himself or from the reach of others;
  • The trustee will likely have more understanding of the tax consequences and make sure the taxes are paid when due; and
  • The trustee, who you trust, can protect and oversee the assets for the benefit of the beneficiary.

When considering what to do with pre-tax assets like IRA’s, 401(k)’s and the like, you need to weigh the advantage of naming individuals (allowing them the opportunity to rollover and to continue to defer the income tax consequences) against other benefits or concerns. If you have minor beneficiaries, or funds will be needed immediately to pay for things like college, or the individual(s) are likely to liquidate the assets anyway, you are or may be better off naming a trust as beneficiary, even though the liquidation of the IRA or qualified plan will trigger the latent income tax consequences.

Keep in mind, as well, that your assessment of these things may change over time. It might make sense to name your trust presently, but that could change as your loved ones mature. Circumstances could also change the other way. An adult child may find herself in financial trouble, or in a bad marriage or may become disabled. These factors may suggest changing from naming them as individually beneficiaries to naming your trust where you can include controls to protect the assets for them.

[i] Qualified trusts allow a rollover option, but the limitations on qualified trusts often work counter to the desires of the person doing the estate planning.

Kevin G. Drendel
Drendel & Jansons Law Group
111 Flinn Street
Batavia, IL 60510
630-406-6179 fax
[email protected]