There has been a long-standing debate about whether inheriting IRA assets in a trust is better than to simply receive the assets directly. A recent U.S. Supreme Court decision has brought this issue to light once again. But there are some things you should consider before making the decision to include an IRA inheritance trust in your estate plan.
Recent court decision makes an IRA inheritance trust a wise choice
The Supreme Court’s decision in Clark v. Rameker has shed light on the need for a strategy when it comes to IRA inheritances. In that case, the plaintiff inherited an IRA from her mother. When she filed for bankruptcy nine years later, she was unable to shield the account from her creditors because she had inherited the account outright. This decision demonstrates just one more reason why creating a trust for an IRA, instead of leaving the account to a beneficiary outright, is a better choice. With an IRA inheritance trust, the funds would be protected from creditors.
The basics on IRA inheritances
Wills typically do not govern the passing on of money in IRA accounts. Instead, an IRA inheritance is passed on according to the beneficiary designation forms that were completed when the IRA account is opened or amended. So, if you want the IRA to be held by a trust after your death, then the IRA inheritance trust must be named as the IRA beneficiary. In general terms, if you inherit an IRA you are required to make minimum withdrawals each year beginning on December 31st of the year the account is inherited. The rules for spouses are a little different.
How does an IRA account work?
An IRA is essentially a tax-deferred savings account, established under applicable IRS guidelines. There are four types of IRAs to choose from. Traditional IRAs and Roth IRAs are opened by individuals, whereas Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) are established through an employer. The employer-sponsored IRAs often include matching investments by the employer.
Each type of IRA is considered “fully vested,” which basically means that all of the contributions and earnings from the IRA, including the matching contributions made by employers, belong to the individual. Contributions are governed by rules and limitations depending on the type of IRA you have. Determining who is allowed to contribute to an IRA also depends on the type of IRA you have.
How are traditional IRAs taxed?
When you make contributions to a traditional IRA, you are not required to pay taxes on those contributions or on the interest the IRA account will earn until you start taking withdrawals during retirement. Put another way, a traditional IRA is funded with “pre-tax” dollars. When you begin withdrawing funds, those withdrawals are taxed as ordinary income. Therefore, if your income is taxed at 20%, and you take a withdrawal of $10,000, you will owe $2,000 in income taxes on that withdrawal.
How IRA “stretch-out” strategies work
There are some “stretch-out” options that may be available. “Stretch-out” is a financial strategy for IRA owners and beneficiaries that allows them to extend the tax advantages already available for an IRA. An heir can stretch out the minimum required distributions over their own expected life spans. Stretching out the IRA gives the funds more time for income-tax-deferred growth.
IRS look-through treatment of IRA inheritance trusts
If an IRA inheritance trust meets certain criteria set by federal regulations, the IRS will “look through” the trust and treat its beneficiaries as if they were directly named as the IRA’s beneficiary. That means the trust can take advantage of favorable minimum distribution rules that apply to individual beneficiaries. If the trust has multiple beneficiaries, the required annual withdrawal will be based on the IRS life expectancy of the oldest beneficiary.
Qualifying for look-through treatment
To qualify for look-through treatment, the trust must meet four criteria outlined in the Code of Federal Regulations. The most problematic requirement in most cases is the requirement that the beneficiaries be identifiable as of the IRA owner’s death. The issue is knowing who the oldest beneficiary will be so that the withdrawals will be based on that person’s life expectancy.
If you have questions regarding an IRA inheritance trust, or any other estate planning needs, contact the Northern California Center for Estate Planning and Elder Law for a consultation, either online or by calling us at (916) 437-3500.
- Gen X – This One’s for You (Really Every Generation Should Read This) - December 10, 2023
- How to Update Your Estate Plan After Major Life Events - December 8, 2023
- Estate Planning for Unmarried Couples: Your Legal Rights - December 6, 2023