Thursday, October 29, 2015

IRA, 401(K), Profit Sharing Beneficiary Designations: Time to Check Them Out

By Les Raatz

For many people, IRAs and qualified plan interests may be their most significant financial asset. Except for Roth IRAs, there will be significant ordinary taxable income when distributions are made from inherited IRAs. (This article will use an IRA as the example, but the same issues generally apply for qualified plan interests.) When the owner dies, unless an exception applies, the entire IRA must be paid out by the end of the 5th calendar year thereafter, or a 50% penalty tax applies to the underpayment. If a $1,000,000 IRA is distributed in the 5th year following death, the maximum income tax rate will apply to the vast portion of the distribution. If the owner’s estate is the default beneficiary, the 5 year rule will be unavoidable.

Generally, only individuals can be named as beneficiaries to be able to “stretch out” the payment beyond the 5 year period, permitting distributions over the persons’ lifetimes. Sometimes that is not advised if, for example, minor children are the intended beneficiaries. So, in many situations, an owner names the other spouse, but if the spouse doesn’t survive, the living trust of the owner is named to hold the assets of the parent for the children, including the IRA interests. That is usually inadequate to avoid the 5 year rule.

Naming trusts as beneficiaries might force the entire IRA to become distributed and taxable quickly, unless the trust has specific provisions. Simply naming the family or living trust will not assure avoiding having to distribute the entire interest over the next 5 years.

Instead, specific trusts for the children created under the family trust should be named. Even then the 5 year rule is not avoided, unless the trust provisions cause the particular trust to be a “see-through” trust, causing the child or children to be deemed to be the “designated beneficiaries” to permit slowing of IRA distributions to be over their lifetimes. The simplest and most assured to qualify see-through trust is a “conduit trust.” It is solely for the benefit of the named persons, but the IRA distributions made to the trust must be immediately re-distributed to the beneficiaries. A much more intricate see-through trust is an accumulation trust, but there are many details that have to be considered and drafting decisions to be made.

For more information, please contact Les Raatz in our Phoenix, Ariz. office at 602-285-5022.