This is another in a series of blogs on the basics of estate planning.
IRAs are one the trickiest assets for estate planning attorneys to handle for many reasons. First, they often are overlooked in the estate planning process because they cannot be transferred during lifetime. This asset, like some other assets, are controlled by beneficiary designation. While the client might remember a large IRA, they often forget smaller IRAs. As a result, beneficiary designations often are left unchanged even when circumstances have changed, making those designations no longer appropriate.
Next, IRAs can be confusing regarding their asset protection characteristics. During lifetime, your own IRA is exempt in bankruptcy under federal law, at least up to $1 million. However, other retirement plans, such as 401ks, are completely exempt. Also, after the death of the owner, the inherited IRA has no asset protection under federal bankruptcy law. This was made clear by the U.S. Supreme Court in Clark v. Rameker (2014), in which the court held that inherited IRAs were not “retirement funds” pursuant to federal exemptions because the funds were not necessarily being saved for retirement like with a participatory IRA. However, there still may be some asset protection pursuant to state law. For example, in California, inherited IRAs are considered “retirement funds” under the California slate of exemptions in bankruptcy, notwithstanding the decision in Clark v. Rameker. See In re Sherr (2016).
Next, traditional IRAs and other traditional retirement assets are included for estate tax purposes at their full value. However, the funds will be subject to income taxation on all distributions when taken, depending upon the income tax bracket of the beneficiary. If the client has a taxable estate, perhaps they should consider converting the IRA to a Roth IRA. This would result in payment of income taxes on the funds being converted. However, beneficiaries will not have to pay income taxes on the funds when withdrawn. Also, the amounts to be paid in income taxes by the client would reduce the client’s estate for estate tax purposes. This is a strategy to consider carefully as there are many factors at play, including current and future estate taxes, income taxes, etc.
Next, if the client is charitably inclined, they might consider naming a charity as the beneficiary of IRAs or retirement plans. The charity pays no income taxes on the assets received. Thus, while other beneficiaries may only receive 60 cents on each dollar due to income taxes, the charity would receive the full dollar.
Finally, the client and attorney should consider leaving the assets in a manner that would allow for the smallest possible required minimum distributions to minimize the income taxation. This might be done in different ways, such as naming younger individual beneficiaries outright (but typically losing asset protection) or naming specially drafted trusts for younger beneficiaries to stretch distributions while maintaining asset protection.
IRAs are complex assets in estate plans for many reasons. Make sure you’ve thought of all the angles.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128