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What I’ve Learned: The Problem With Bequeathing an IRA

Middle Aged Couple Meeting With Estate Attorney

“Any gift should be greatly appreciated, but IRAs are my least favorite asset to plan (or receive) as a bequest.

An IRA is in Individual Retirement Account.  It is a savings account that is managed by a third person.  The account grows income tax free. The IRA owner is taxed when the funds in the account are distributed to the owner.  The tax that is paid is income tax on the distribution amount. If IRA money is taken out too soon, it is subject to a 10% penalty.  Once a person turns 70 1/2, he or she must take out a minimum required distribution amount each year. An IRA that is directly inherited is also subject to a minimum required distribution, but the amount is figured based upon the projected lifespan of the beneficiary (if the beneficiary is a non-spouse and the person is younger than the decedent).

The manager of an IRA will have the owner name a beneficiary or beneficiaries via a beneficiary designation.  Unless a person names his or her estate the beneficiary of an IRA, nothing in a will has any effect on an IRA. This can make it tricky to do estate planning if the idea is to give beneficiaries a percentage of an estate – for instance, where I want three people to each inherit 1/3 of my estate.

For instance, say I have a $200,000 IRA, a $400,000 in CDs, a husband, and two adult children.  I don’t want to name my husband as a beneficiary of the IRA, because he is 75 years old, and the IRA required minimum distributions from my IRA would put him in the next higher income tax bracket, which we don’t want.  But what if I DO want to have my estate divided in thirds, so that each person gets $200,000?

I could make one child the beneficiary of the IRA, and make my husband and the other child of the  beneficiaries of ½ of my estate (the CDs). But then if I spend my $400,000 during the rest of my life and my IRA grows, my Husband may end up with significantly less than the child who inherited the IRA.  The child who inherited the IRA may not be so happy, either. She wanted to use the money for a down payment on her first house, but learned if she did that, she would have to pay about $70,000 in income taxes.

I could make my estate be the beneficiary of the IRA and have my will say everyone receives 1/3 of the estate.  But if I do, if I die before I am 70 ½ years old, or I have a Roth IRA, then the the estate will cash out the IRA within one year to five years (and it must be cashed out by 5 years) and pay income taxes at the estate tax rate of 39.6%.  That would be $73,000.

When someone inherits an IRA directly, they will be told it is a wonderful investment tool, since it grows income tax free as long as the money is kept in the IRA.  However, retirement funds are the only kind of inheritance you have to pay income tax on, and many people are not excited about taking their money in little bits over time in order to save on taxes.  Also, the beneficiary has to start taking a required minimum distribution within the year of inheriting it, so they will also be paying that income tax soon after the death. Finally, the rules around inherited IRAs are complex and unforgiving, and failing to follow them is costly.

When consulting a Denver estate planning attorney and doing annual financial planning, it is good to keep this all in mind.  When there is a choice, spending down retirement funds and preserving other assets to leave those who survive you is something to consider” (Willoughby).

 

Willoughby, K. R. Esq., Genesee Living Magazine.

 

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