Consider the Complexity and Uncertainty of the Rules
As will be discussed in the following sections of this Report, there is considerable complexity and uncertainty in determining how the IRS and your particular IRA administrator will manage the issue of taxation in the case of the death of the owner. Some plan administrators require withdrawal of the IRA balance within a period of one to five years, even though the IRS might allow a greater number of years. You should consider that uncertainty when making your estate planning decisions.
As an example, if you simply name your spouse as the beneficiary of your IRA, you and your spouse can be assured of the maximum income deferral benefits for each of you. However, that form of planning may increase the estate taxes on your estate, ultimately affecting the amount of inheritance your children receive.
Steps in the Planning Process
Initially, a decision must be made concerning which family members are intended to benefit from the estate plan. Each choice may have important tax consequences. For the remainder of the report, we will assume that Mr. and Mrs. Smith and their two children are the family for whom we will plan. Let’s look at the unique issues involved in IRA planning.
Estate Tax Planning
All to the spouse - One option available to married couples is for each spouse to name the other as the beneficiary of the owner’s IRA. When the owner spouse dies, the surviving spouse will own the IRA and there will be no estate taxes imposed because bequests to a spouse are protected by the Unlimited Marital Deduction. This is a simple plan that protects the surviving spouse from estate taxes or income tax uncertainty. However, this method may cause Mr. and Mrs. Smith’s children to bear the burden of paying estate taxes out of their inheritance that are otherwise avoidable. How would that happen?
Let’s assume, for a moment, Mr. Smith has an IRA with a balance of $1 million and Mrs. Smith also has property with a value of $1 million. If Mr. Smith names Mrs. Smith as the beneficiary of his IRA, at his death, Mrs. Smith will own her own property and Mr. Smith’s IRA. If Mrs. Smith dies a couple years later, she will have a taxable estate of $2 million. As you know, each person dying in 2011 or 2012 can leave $5 million without estate taxes being imposed. However, in 2013 and thereafter it is only $1 million per person. Thus, Mr. and Mrs. Smith could have left their children a combined value of $2 million, consisting of $1 million from each parent. However, the “simple” plan of naming Mrs. Smith as the beneficiary has erased the ability to use Mr. Smith’s exemption because his assets were combined with hers and she subsequently died with a $2 million estate. The Smith children will have to pay estate taxes of $435,000 at their mother’s death. A “simple,” but expensive estate plan for the IRA.
Is there a way to avoid the $435,000 estate tax bill? Yes, Mr. and Mrs. Smith may use a specially prepared trust to receive the rights to Mr. Smith’s IRA. When Mrs. Smith dies, the balance of Mr. Smith’s IRA will be owned by the Trust and not taxable in Mrs. Smith’s estate as when she was his beneficiary. The Trust pays all of its income to Mrs. Smith and principal for her health, education, maintenance or support. Mrs. Smith is economically protected and the children inherit the entire $2 million. However, say goodbye to “simplicity.” With the trust having become the current IRA beneficiary, the $1 million IRA is subject not only to IRS rules but the potentially stricter rules of the IRA Administrator. Let’s review the IRS distribution rules.