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.”