Each year, IRA and 401(k)s are required minimum distributions. Because the distributions start at about 4% at age 71 and then slowly increase, many IRA and 401(k) plans continue to grow in value. While distributions eventually become larger, most people pass away with an IRA or 401(k) close to the value of their original plan.
For this reason, having distribution options is important. In fact, the IRA or 401(k) may be the largest asset in your estate.
IRA and 401(k)s are transferred to the beneficiary that you selected on your IRA or 401(k) form. The five common choices are the surviving spouse, children, charity, a trust for children or a trust for spouse and children.
1. Spouse as Beneficiary
The most common choice for a married couple is to select the surviving spouse as the designated beneficiary. The surviving spouse then has two choices: to receive payments under a one-life expectancy schedule or roll over the IRA into their own IRA.
Because the payments under the IRA schedule are frequently double the required payments with the rollover, nearly everyone rolls over the IRA into his or her own plan.
2. Children
For the surviving spouse, the IRA or 401(k) may be transferred to the children.
There are two methods for doing this. First, each child receives a fraction of the plan and then takes distributions based on their own life expectancy.
Second, if there is a class designation with the IRA designated to a group of children or other heirs, then the age of the oldest beneficiary determines the payout schedule.
As you can see, it is usually best with several children to allocate a fraction to each child because of the payout calculation method.
Does your child have to take the stretch payout? No, but taking the distribution early means paying the income tax earlier and losing the benefit of tax-free growth for their own life expectancy. Parents who wish to encourage lifetime IRA distribution may use a testamentary trust to hold the IRA and payout over the child’s life expectancy.
3. Charity
Designating children as the beneficiaries means the IRA or 401(k) is transferred with a large “you owe the IRS” tax bill attached. For the vast majority of plans, the child will pay income tax. Worse yet, the distributions might push the child into a higher tax bracket.
There is an alternative. Because no income tax is paid on the home, land or stocks that are transferred to children, they may be better off receiving a home, land or stock with no income tax bill attached. The wise planning decision may be to transfer the home, stocks or land to children, and the IRA or 401(k) to charity.
Because charities are tax exempt, they are not subject to income tax or estate tax. The charity receives the full value tax-free.
4. Give it Twice Trust
A very good plan for parents who have made lifetime gifts to charity is to combine a benefit to children with a future benefit to charity. This plan is called a “Give It Twice” trust.
A charitable remainder trust may receive the IRA or 401(k) with no payment of income tax. The full value of the IRA or 401(k) may be invested for a term of up to 20 years. Income earned is taxable and that new income is paid to children for the selected term of years. At the end of that term, the charity receives the trust principal.
Here’s an example of how that works. Mary Smith has an $800,000 estate. She lives in a home worth $200,000, has a CD for $200,000 and $400,000 in her IRA. Her IRA is substantial because when her husband Bill passed away, she rolled over his IRA into hers so the combined IRA is now half of her estate.
Mary has two children and decides to transfer the home and CDs to the children in equal shares when she passes away. They each receive $200,000 in value from the home and CDs with no income or estate tax.
The $400,000 IRA is transferred into a charitable remainder trust. It receives the IRA proceeds and invests the full $400,000. The trust pays 5%, which is divided between the two children for a term of 20 years. At the end of 20 years, the trust principal plus growth is given to charity.
In doing so, Mary achieved several goals. First, she provided both principal and income to her children. Second, she saved all of the income tax on the IRA. Because the unitrust is tax exempt, it receives the entire IRA tax-free. The trust earns income for the children for 20 years and is then transferred tax free to charity.
Because the trust benefits the children with more than $400,000 in income and then is given to charity, it truly may be called a “give it twice” trust.
5. Trust for Spouse and Children
For individuals with larger estates, it may make sense to create a trust for the surviving spouse and then a term of years for children. The IRA is transferred after the first spouse passes away into the trust for the surviving spouse. The trust will distribute income for his or her lifetime and then to the children for a term of 20 years. Following the life of spouse plus 20 years for the children, the trust remainder is distributed to charity.
This trust has several benefits. First, it may save very large income taxes because the trust is tax exempt. Second, the trust can be a “net plus makeup” plan that allows the spouse to choose to save taxes by taking reduced income during life. This will allow the IRA to continue to grow and build up the trust so there is greater income to the children.
This plan is an excellent way to benefit the surviving spouse, children and charity.
Article published in Gift Legacy
