The Importance of IRA Distribution Planning

Many times parents with young children do not want to spend the time or resources to comprehensively plan their estates if one or both parents were to die.  They think that the chance is so remote that there are more important things to do, especially with their time and hard earned dollars.  While the optimist in me agrees, the practical estate planning lawyer does not.  Unfortunately, young parents die frequently, many times without comprehensive estate planning.

If a minor child is named as the beneficiary of an IRA or other retirement plan (or life insurance policy), then in almost all states, a guardian has to be appointed for the child in court (even if the other parent is still alive), and the investments and distributions from the guardianship account are often controlled by state law and the courts.  This normally means restrictive investments and hard to obtain distributions.  In some jurisdictions, like the District of Columbia, the courts are more and more reluctant to name family members or relatives as the guardian of a minor’s property.  Instead the courts name an attorney or trust company.  What this means is added cost.  Besides the restrictions and costs, almost all guardianships end when the minor reaches the age of 18.  That means that a very young adult will now have full control and responsibility over their inheritance. As many of my readers know, this may not be a very good idea.

Therefore naming the minor child as a direct beneficiary of an IRA, retirement plan or life insurance policy is generally a very bad idea.  Instead, a trust should be named as the beneficiary of the IRA, retirement plan or life insurance policy.  The trust can be a separate standalone trust, or a trust created under someone’s Will or a trust created under someone’s living or revocable trust.

When a trust is named as the beneficiary of an IRA or other retirement account, when someone dies, normally an inherited IRA is created and the IRA is controlled by the terms of the trust, under control of a trustee selected by the parent.  This is a good thing and it requires coordination between the parents estate planning documents and the beneficiary designation of the IRA, retirement account or life insurance policy.  This takes some thought, time and resources, but it is necessary insurance in case the unthinkable happens.

Our story is not done yet.  Unfortunately, many Wills are not drafted appropriately to allow for an IRA or other retirement account to be tax efficiently received by a trust created under the Will.  Under the IRA rules, when a trust is named as a beneficiary of an IRA or other retirement account, the trust must have certain characteristics in order to allow the IRA to be paid out over the oldest beneficiary of the trust, normally the oldest child. If a trust is not properly drafted, then, upon the parent’s death, the IRA must be  withdrawn within a 5 year period, therefore triggering income taxes much sooner than necessary.  The difference between 5 years and the lifetime of a parent’s oldest child is normally 65 to 75 years.  These extra years dramatically increase the amount available to the parent’s children, due to tax deferred growth of the IRA (after the parents death).

A recent case illustrates how easy it is for a Will or trust to be drafted to accelerate the IRA distributions.  In determining who is the oldest beneficiary of the trust, you must look at all possible beneficiaries of the trust, i.e., any person who, under any possible scenario or set of facts, could, at any time, receive any accumulated required minimum distribution paid to the trust.  It does not matter how remote this possibility is.  It is only important that the chance exists.  In this case, the Will (and trust created under the Will) states that, if all of the parent’s children are deceased (and if they had no children of their own), the assets in the trust would be paid to the parent’s heirs under the intestate laws (who receives assets when someone dies).  That typically means parents, brothers and sisters, nieces and nephews, grandparents, aunts and uncles, etc.  So instead of a life expectancy for a minor child, the IRA may be required to be withdraw over the life expectancy of a 95 year old grandparent, or 65 year old parent or 76 year old aunt or a 49 year old sibling.  In any of these situations, the IRA will be paid out over a quicker schedule, therefore resulting in more income tax paid sooner, and less income tax deferral, so the end result is less money for the children, which is not normally the goal or objective.

The bottom line is that estate planning to too important to delay or to attempt to do on your own.  One misstep could cost your children thousands, if not hundreds of thousands, if not millions, of dollars in lost tax deferred growth.  Plan your estate comprehensively and completely with a lawyer well versed in all aspects of estate planning, IRA distribution planning, both from a legal and a practical point of view.

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