IRAs in Estate Planning

Individual Retirement Accounts (IRAs) offer tax advantages and are popular investment tools for retirement. But there are some special estate planning considerations for IRAs as part of your estate. Without proper planning, your IRA may become a tax nightmare for your heirs.

IRA Basics

There are two basic types of IRAs used for retirement planning: the traditional IRA, and a Roth IRA. The advantage of a traditional IRAs is that you generally can deduct your contributions to an IRA from your taxes. Earnings in a traditional IRA generally are not taxed until distributed. At age 70 1/2 you must start taking distributions from a traditional IRA.

A Roth IRA allows the account to grow tax-free and not pay any taxes on the earnings and increased value…ever. (By comparison, in a traditional IRA, the earnings grow tax free but then every dollar is taxed when distributed.) The trade-0ff is that contributions to a Roth IRA are not tax deductible.

At your death, your remaining IRA balance can be paid to your named beneficiary or beneficiaries.

Naming Beneficiaries

You will need to name a beneficiary for your IRA. Generally you will name a primary beneficiary (usually the surviving spouse, if any), and then contingent beneficiaries.

Your spouse gets special tax treatment for the IRA, because he or she can roll over the IRA into his or her own IRA and likely defer taxes when the surviving spouse is younger than the deceased spouse. When a non-spouse inherits and IRA, the beneficiary must start taking distribution within a year after the IRA owner dies.

Failure to name a beneficiary, or naming a beneficiary who has died without naming an alternate beneficiary, means the the IRA would go to your estate and be subject to probate (the court-supervised process of estate administration) and incur extra court costs. In addition, the estate generally must fully withdraw the IRA over a five-year period, losing the ability to “stretch” the IRA through tax-free growth and spreading out taxes over a longer time.

Stretching an IRA

Stretching an IRA means taking only minimum distributions, to provide for a bigger inheritance for your beneficiaries i.e., your family. When you die, your beneficiary also can stretch distributions out over his or her lifetime; then he or she can name a second-generation as beneficiary of the remainder. For more information on stretching out an IRA, click here.

Trusts as Beneficiaries

For some planning, it may make sense to name a trust as a beneficiary. This is particularly true if you have minor children, children with special needs, or a beneficiary who can’t handle their own finances. But if the goal is to allow for the longest IRA “stretch” the trust must be properly drafted. Generally if the trust is a “see-through” trust or “conduit” trust, then distributions from the IRA to the trust after the IRA owner’s death can be stretched out over the life expectancy of the oldest trust beneficiary. Proceed with caution when you’re planning to leave your IRA to a trust, and consult with a qualified attorney about the trust and the terms of the beneficiary designation.

IRAs are popular and a big part of many peoples’ estate plans. But the rules are complicated so be sure to get experienced professional guidance before your family faces a big and unexpected tax bill.