For clients with significant assets, retirement planning may include what to do with retirement assets that are left over when the client dies. It sounds like a nice problem to have, but clients’ desires to pass wealth on to their family may be hamstrung if they use the wrong tools.
Particularly with qualified retirement accounts like 401(k)s, where the real value is the ability to grow assets tax deferred, it can be especially challenging to protect those assets so the clients’ beneficiaries actually get to use them, according to John Goralka, a partner in Sacramento-based Goralka Law Firm, which specializes in taxation, estate planning and probate and trust law.
For example, say you have a 50-year-old beneficiary who inherits a $200,000 IRA. “If that account’s growing at a 6% clip, that 50-year-old child can withdraw $700,000 out of that IRA and there still would be $300,000 left in that account. So that $200,000 IRA is actually worth $1 million” by the time the beneficiary is ready to start making withdrawals.
When a retirement account is transferred from one generation to the next, Goralka told ThinkAdvisor on Monday, “growth of four to five times is really very common.”
However, when assets are passed on to a client’s grandchildren, “instead of four to five times growth, you’re looking at 10 to 12 times growth or more, depending on the ages, so the numbers are really very, very significant,” Goralka said.
“Part of the problem – and a lot of people are not aware – is that if you use a regular living trust, it typically will not qualify for this deferral of tax,” he noted.
A living trust, which is commonly used to avoid probate fees, “can be a very strong mechanism” to protect assets inherited from a nonqualified account from future lawsuits, claims by creditors, bankruptcies or divorce settlements, but it’s not the ideal tool to use to pass on assets from qualified retirement accounts, he said.
One challenge in protecting those assets is the age of the beneficiary. As part of the Pension Protection Act of 2006, Goralka said, “if you have a qualified account being inherited by a non-spouse beneficiary, then you can use their ages [for RMD purposes].”
That means if the beneficiary is very young, you may have to protect them from themselves. Goralka used his son as an example.
“My son Patrick is 21 years old. If something happened to me and he inherited my IRA right now, if he treats it properly, those funds can grow on a tax-deferred basis for 49 years until he’s 70 and half. Forty-nine years of tax-deferred growth is really very, very, very substantial.”
However, if he withdraws the funds, “once it comes out, instead of a stretch-out, it’s kind of like a blowout; it’s like a flat tire that you can’t fix because once the funds are pulled out of that qualified account, you really can’t put it back.”
An IRA trust or a retirement account trust assures clients that assets won’t be used until the beneficiary is old enough to withdraw them wisely.
Another problem is that assets in inherited IRAs aren’t protected from claims on them by interested parties. Goralka referred to a 2014 opinion by the Supreme Court, Clark v. Rameker, which found assets in inherited plans are not considered “retirement funds” as far as section 522(b)(3)(C) of the Bankruptcy Code is concerned.
Then there’s the potential to lose retirement assets in a divorce settlement. “There’s actually an incentive in the Internal Revenue Code,”Goralka said, “so if a spouse is able to take those funds, they can do it on a tax-free basis.”
A qualified domestic relations order, or QDRO, allows a divorcing spouse to receive benefits from a qualified retirement account tax-free and roll them over just as if they were a participant in the plan.
“Unless you’re Paul McCartney with a huge estate, in most divorces both spouses inflict a certain amount of emotional, economic and legal pain on each other and then it settles,” Goralka said. “If they’re able to get their hooks into [an inherited IRA] through that settlement process, then all that tax-free growth goes with it. So with that $200,000 account that’s going to grow to $1 million, say the spouse takes half of that, now all that’s left is the $100,000 for the child, and the other $100,000, which is going to grow to $500,000, is now taken by the ex-spouse.”
Because these assets tend to appreciate more quickly than others, they’re high on the list of things that a spouse will try to get through divorce proceedings, he added.
Goralka said using a retirement trust as a designated beneficiary isn’t necessarily a well-known strategy among financial advisors. “A lot of times, because the rules regarding qualified plans are very technical,” advisors may not know how to best use a trust as a designated beneficiary for their clients’ specific situations. “Again, this stretch is designed on what the age of the beneficiary is, so how do you know what that age is? What if the trust is providing for five beneficiaries?”
In that case, the separate shares for each beneficiary should be referenced on the beneficiary form itself. “We want to make sure each child’s age can be used” for the stretch-out, Goralka said.
He added that the trust itself can cause it to be disqualified if “you’re not able to show that all of the funds are going to be going to the designated beneficiary during their lifetime. It can be disqualified if they’re being used to pay estate taxes, for example; even if it’s hypothetical it can create a disqualification.”
For that reason, “it’s very hard for a regular trust to qualify, but a retirement inheritance trust is designed specifically to hold only retirement accounts, and it’s carefully drafted to include the specific provisions required in the Internal Revenue Code for it to qualify,” he said.
It’s important to note that whether assets will qualify for tax deferral isn’t decided by the IRS, but the plan administrator. “When there’s a death, the plan administrator is going to review [the plan], and decide whether that trust meets those requirements. A regular living trust often does not.”
When an IRA is inherited by a child, cashing the check will prevent them from ever getting access to that tax-deferred growth. IRAs inherited by a spouse have a grace period, when they can return funds to the account, Goralka said.
He suggested using a team approach and working with clients and their estate planning attorneys to make sure clients’ desires are being carried out. He also stressed the importance of making sure beneficiary designations have actually been made.
“It sounds silly, but often these beneficiary designations, because they’re so simple, they’re overlooked.”
In that case, the assets could be subject to taxation and probate fees, as well.
That means keeping a copy, as well. “More firms are using online designations. The concern I have with that is being able to show what you’ve done. If you’re doing an online designation, you want to make sure you can do a ‘print screen’ or get a copy of that,” he advised.
— Read RMDs From Client IRAs: An Unconventional ESA Funding Tool on ThinkAdvisor.