Frequently Asked Questions
Understanding Who Should Be Beneficiary of Your IRA
How would you like to turn your modest tax-deferred account into millions for your family? Depending on whom you name as beneficiary, you can keep this money growing tax-deferred for not only your and your spouse’s lifetimes, but also for your children’s or grandchildren’s lifetimes. That can turn even a modest inheritance into millions.
When you reach a certain age, usually April 1 after you are 70 1/2, Uncle Sam says you must start taking some money out. (This is called your required beginning date.) But if you do not use all this money before you die, naming the right beneficiary can keep it growing tax-deferred for decades.
Calculating the amount you must withdraw each year (your required minimum distribution) is much easier now than it used to be. Each year, you divide the year-end value of your account by a life expectancy divisor from the Uniform Lifetime Table (provided by the IRS). The result is the minimum you must withdraw for that year. You can always take out more.
For example, the divisor at age 70 is 27.4. If your year-end account balance is $100,000, you divide $100,000 by 27.4, making your first required minimum distribution $3,650. Each year the divisor is smaller, but it never goes to zero. Even at age 115 and older, the divisor is 1.9. “To recalculate or not recalculate” is no longer an issue. Everyone now gets the benefit of recalculating his/her expectancy.
Not any longer. Now, almost everyone uses the same chart to calculate distributions, even if you have no beneficiary. After you die, distributions are based on your beneficiary’s life expectancy (or the rest of your life expectancy if you die without one.) Naming the right beneficiary is still critical to getting the most tax-deferred growth. That’s much easier to do now, because you are no longer locked into the beneficiary you name when you take your first distribution.
Most married people name their spouse as beneficiary. That’s because 1) the money will be available to provide for the surviving spouse and 2) the spousal rollover option can provide many more years of tax-deferred growth.
Also, if your spouse is more than ten years younger than you are, you can use a different life expectancy chart that makes your required distributions even less. (This lets the tax-deferred growth continue longer on more money.)
If you die first, your surviving spouse can “roll over” your tax-deferred account into his/her own IRA, further delaying income taxes until he/she must start taking required minimum distributions on April 1 after age 70 1/2.
When your spouse does the rollover, he/she must name a new beneficiary, preferably someone much younger, as your children and/or grandchildren would be. After your spouse dies, the beneficiary’s actual life expectancy can be used for the remaining required minimum distributions. The results, shown in the chart below, can be phenomenal.
For example, let’s say your grandson is 20 when he inherits a $100,000 IRA from your spouse. Over the next 63 years (the life expectancy of a 20-year-old), the $100,000 IRA can provide him with over $1.7 million in income!
Under current IRS policy, your spouse can do this rollover and stretch out the IRA even if you had started taking required minimum distributions before you died.
TOTAL INCOME FROM IRA OVER BENEFICIARY’S LIFETIME*
Age 20, Life Expectancy 63.0 Years
Value of $50,000 IRA When Inherited by Beneficiary = $882,865
Value of $100,000 IRA When Inherited by Beneficiary = $1,765,731
Value of $500,000 IRA When Inherited by Beneficiary = $8,828,658
Age 30, Life Expectancy 53.3 Years
Value of $50,000 IRA When Inherited by Beneficiary = $526,612
Value of $100,000 IRA When Inherited by Beneficiary = $1,053,225
Value of $500,000 IRA When Inherited by Beneficiary = $5,266,128
Age 40, Life Expectancy 43.6 Years
Value of $50,000 IRA When Inherited by Beneficiary = $321,210
Value of $100,000 IRA When Inherited by Beneficiary = $642,421
Value of $500,000 IRA When Inherited by Beneficiary = $3,212,106
Age 50, Life Expectancy 34.2 Years
Value of $50,000 IRA When Inherited by Beneficiary = $201,067
Value of $100,000 IRA When Inherited by Beneficiary = $402,134
Value of $500,000 IRA When Inherited by Beneficiary = $2,010,671
* Assumptions: 7% annual return; only required minimum distributions withdrawn. Income subject to income taxes.
If you don’t remarry, you lose the rollover option. This used to be a problem, because distributions after your death would still be based on your and your deceased spouse’s life expectancies. But now you can name a new beneficiary, and after you die the distributions will be based on the new beneficiary’s life expectancy.
Your spouse will have full control of this money after you die and is under no obligation to follow your wishes. This may not be what you want, especially if you have children from a previous marriage or feel that your spouse may be too easily influenced by others after you’re gone.
Also, if your spouse becomes incapacitated, the court could take control of this money. It could be lost to your spouse’s creditors. And, finally, naming your spouse as beneficiary can cause your family to pay too much in estate taxes. (More about this later.) If any of this concerns you, keep reading.
If your spouse will have plenty of assets after you die, if you have reason to believe your spouse will die before you, or if you are not married, you could name your children, grandchildren or other individuals as beneficiary(ies). Because the distributions can be paid over your beneficiary’s life expectancy after you die, the tax-deferred growth can continue even without the spousal rollover.
Anytime you name an individual as beneficiary, you lose control. After you die, your beneficiary can do whatever he/she wants with this money, including cashing out the entire account and destroying your carefully made plans for long-term, tax-deferred growth. The money could also be available to the beneficiary’s creditors, spouses and ex-spouse(s). And there is the risk of court interference at incapacity. If any of this concerns you, consider using a trust.
Naming a trust as beneficiary will give you maximum control over your tax-deferred money after you die. That’s because the distributions will be paid not to an individual, but into a trust that contains your written instructions stating who will receive this money and when.
For example, your trust could provide income to your surviving spouse for as long as he or she lives. Then, after your spouse dies, the income could go to someone else. The trust could even provide periodic income to your children or grandchildren, keeping the rest safe from irresponsible spending and/or creditors.
While you are living, the required minimum distributions will still be paid to you over your life expectancy. After you die, the required distributions can be paid to the trust over the life expectancy of the oldest beneficiary of the trust.
The trustee can withdraw more money if needed to follow your instructions, but the rest can stay in the account and continue to grow tax-deferred. You can name anyone as trustee, but many people name a bank or trust company, especially if the trust will exist for a long period of time.
You will not be able to provide for your spouse and stretch out the tax-deferred growth beyond your spouse’s actual life expectancy. That’s because you must use the life expectancy of the oldest beneficiary of the trust which, in this case, would probably be your spouse.
Also, many trusts pay income taxes at a higher rate than most individuals, but this only applies to income that stays in the trust. Distributions from your tax-deferred account that are paid to the trust are subject to income taxes and if the money stays in the trust, the higher tax rates would apply. But usually this is not a problem because the trustee has authority to distribute the money to the beneficiaries of the trust, who pay the income taxes at their own rates.
Finally, the trust must meet certain IRS requirements, including that it is a valid trust under state law. It is advantageous to create an irrevocable Retirement Benefit Trust, also called a Stand-alone Retirement Trust, and to name this trust as the beneficiary on your beneficiary designation form.
If you are planning to leave an asset to charity after you die, a tax-deferred account can be an excellent one to use. That’s because the charity will pay no income taxes when it receives the money, and the account will not be included in your taxable estate when you die, reducing the amount your family may have to pay in estate taxes. (More later.)
You don’t have to choose just one of these options. You can divide a large IRA into several smaller ones and name a different beneficiary for each one. (If your money is in an employer’s plan, you can roll it into an IRA and then split it.)
If you name several beneficiaries for one IRA, the oldest one’s life expectancy will determine the payout after you die. But with separate IRAs (one for each beneficiary), each life expectancy will be used, providing the maximum stretch out.
This is especially important if a charity is involved. It has a life expectancy of zero, so the IRS would consider it the oldest beneficiary. Depending on when you die, this could cause the entire IRA to be paid out in just five years.
If you divide your IRA now, you will need to calculate a distribution for each one, but it can be worth the trouble. Under the new rules, your IRA can be divided even after you die. Splitting a large IRA can also save estate taxes.
You can change your beneficiary at any time while you are living, and the distributions after you die will be paid over that beneficiary’s life expectancy (unless they cash out).
It is very important to name both primary and contingent beneficiaries while you are living to allow for greater flexibility and “clean up” after your death. For example, your spouse could disclaim some benefits so a grandchild could inherit. No new beneficiaries can be added after you die (unless your spouse names new ones with a rollover), so make sure you include all appropriate ones.
Some employer-sponsored plans (401(k), pension and profit sharing plans, etc.) have restrictions on beneficiary distribution options. But under a new rule, any beneficiary may now inherit employer plan assets and roll them into an IRA in the name of the decedent, continuing the tax-deferred growth over the beneficiary’s own life expectancy. (Some restrictions apply.)
If your plan will not let you do what you want, rolling your account into an IRA will usually give you more options. If your money is already in an IRA and the institution will not agree to your wishes, move your IRA to one that will.
If you qualify, you may want to convert some or all of your tax-deferred money into a Roth IRA, but you’ll have to pay taxes on the amount you convert. Also, if you qualify, you can make after-tax contributions to a Roth IRA.
Unlike a traditional IRA that requires the participant to start taking money out on April 1 after age 70 1/2, there are no minimum distributions required during the participant’s lifetime with a Roth IRA. And, generally, after five years or age 59 1/2 (whichever is later), all withdrawals are income tax-free. So you can leave your money there, growing tax-free, for as long as you wish. However, remember that once your Roth IRA is distributed to a non-spouse beneficiary, required minimum distributions come into play.
You can stretch out a Roth IRA just like a regular IRA. After you die, distributions can be paid over the actual life expectancy of your beneficiary. Your spouse can even do a rollover and name a new beneficiary. And, remember, all distributions to your beneficiaries will be income tax-free.
Yes. Even though the rules are now simpler, they are still loaded with tax traps and penalties. Make sure you get expert advice, especially if you have a sizeable amount in tax-deferred plans and your estate is large enough to pay estate taxes.
Understanding Funding Your Living Trusts
Funding your trust is the process of transferring your assets from you to your trust. To do this, you physically change the titles of your assets from your individual name (or joint names, if married) to your name(s) as trustee(s) of your trust.
The trustee you name will control the assets in your trust. Most likely, you have named yourself as trustee, so you will still have complete control. One of the key benefits of a revocable living trust is that you can continue to buy and sell assets just as you do now. You can also remove assets from your living trust should you ever decide to do so.
If you have signed your living trust document but haven’t changed titles and beneficiary designations, you will not avoid probate. Your living trust can only control the assets you put into it. You may have a great trust, but until you fund it (transfer your assets to it by changing titles), it doesn’t control anything; your living trust can only control the assets you put into it. If your goal in having a living trust is to avoid probate at death and court intervention at incapacity, then you must fund it now, while you are able to do so.
Along with your trust, your attorney will prepare a “pour over will” that acts like a safety net. When you die, the will “catches” any forgotten asset and sends it to your trust. The asset will probably go through probate first, but then it can be distributed according to the instructions in your trust.
You are ultimately responsible for making sure all of your appropriate assets are transferred to your trust. Typically, you will transfer your assets to your trust. Wright & Wright is unique in that we assist you with the initial funding of your trust and the review of your beneficiary controlled assets.
It’s not difficult, but it will take some time. Because living trusts are now so widely used, you should meet with little or no resistance when transferring your assets. At Wright & Wright, we adopt a “team” approach to fuding. Our firm can assist you with preparing the transfer documents for most assets, but for such things as bank accounts, you will need to go your financial institution to sign new signature cards.
Some institutions will want to see proof that your trust exists. To satisfy them, Wright & Wright prepares a Certificate of Trust. This is a shortened version of your trust that verifies your trust’s existence, explains the powers given to the trustee and identifies the trustees, but it does not reveal any information about your assets, your beneficiaries and their inheritances.
While the process isn’t difficult, it’s easy to get sidetracked or procrastinate. The team at Wright & Wright is here to help and encourage. As part of planning process, we have created a Trust Financial Statement, which guides and documents when there is a change in title. Remember why you are doing this, and look forward to the peace of mind you’ll have when the funding of your trust is complete.
The general idea is that all of your assets – bank accounts, investment accounts, business interests, notes payable real property, etc. should be in your trust. The common exceptions are annuities, IRAs and retirement plans.
Understanding Estate Taxes
Estate taxes are different from and in addition to probate expenses, which can be avoided with a revocable living trust, and final income taxes, which must be paid on income you receive in the year you die.
Federal estate taxes are expensive (historically, 35%-55%) and they must be paid in cash, usually within nine months after you die. Because few estates have the cash, it has often been necessary to liquidate assets to pay these taxes. But, if you plan ahead, you can reduce and even eliminate estate taxes.
Your estate will have to pay federal estate taxes if its net value when you die is more than the exempt amount set by Congress at that time. The federal exemption was set at $5 million in 2011 and is adjusted annually for inflation; every dollar over the exempt amount is taxed at 40%.
To determine the current net value, add your assets, then subtract your debts. Include your home, business interests, bank accounts, investments, personal property, IRAs, retirement plans and death benefits from your life insurance.
If you are married, use both estate tax exemptions.
Remove assets from your estate before you die.
Buy life insurance to replace assets given to charity and/or to pay any remaining estate taxes.
If your spouse is a U.S. citizen, you can leave him or her an unlimited amount when you die with no estate tax. But there can be problems when the second spouse dies.
For example, let’s say Chris and Terry have a combined net estate of $10 million. When the Chris dies, everything is left to Terry, so no estate taxes are due at Chris’ death. When Terry dies, the estate of $10 million uses Terry’s $5 million exemption. This has been traditional planning for many married couples, but the problem is they waste Chris’ exemption. With this approach, the tax bill on the remaining $5 million is a whopping $2 million!
Congress tried to fix this. Now, the executor of Chris’ estate can transfer his unused exemption to Terry by filing a federal estate tax return at Chris’ death. But if Terry remarries and outlives her new spouse, she would lose Chris’ unused exemption. Also, by leaving everything to Terry, Chris has no control over how his share of the assets are managed or distributed. Plus, any growth on the assets will be included in Terry’s estate and taxed when she dies.
If Bob and Sue plan ahead, they can use both exemptions and solve these problems. A tax-planning provision in their living trust splits their $10 million estate into two trusts of $5 million each. When Bob dies, his trust uses his $5 million exemption. When Sue dies, her trust uses her $5 million exemption. This reduces their taxable estate to $0, so the full $10 million can go to their loved ones.
This also lets Bob keep control over how his share of the estate is managed and distributed (important if he has children from a previous marriage). The assets are valued and taxed only at his death, so no growth is included in Sue’s estate. And the assets in Bob’s trust can be available for anything Sue needs.
Married couples with estates of all sizes find these benefits appealing. (This planning can also be done in a will, but you would not avoid probate or enjoy the other benefits of a living trust.)
One way to reduce estate taxes is to reduce the size of your estate before you die. So go ahead and spend some, and enjoy it. Also, you probably know whom you want to have your assets after you die, so why not make some gifts now? It can be very satisfying to see the results of your gifts, something you can’t do if you wait until you die.
Appreciating assets are best to give because any future appreciation will also be out of your estate. Gifted assets keep your cost basis (what you paid for them), so recipients may pay capital gains tax when they sell. But the top capital gain gains rate (20%) is still less than the estate tax rate (40%) that would apply if you hold onto the assets until your death.
Some popular strategies are introduced below. Note that these are irrevocable, so you can’t change your mind later.
Federal law now lets you give up to $14,000 ($28,000 if married) to as many people as you wish each year. So if you give $14,000 to each of your two children and five grandchildren, you will reduce your estate by $98,000 a year (7 x $14,000), $196,000 if your spouse joins you. (This amount is adjusted from time to time due to inflation.) State laws may differ.
If you give more than this, the excess will be considered a taxable gift and will be applied to your $5.25 million ($10.5+ million if married) “unified” gift and estate tax exemption. (If you use it while you are living, it’s considered a gift tax exemption; if you use it after you die, it’s an estate tax exemption.) Charitable gifts are still unlimited. So are gifts for tuition and medical expenses if you give directly to the institution.
Depending on your age and health, buying life insurance can be an inexpensive way to replace an asset given to charity and/or to pay any remaining estate taxes. The three-year rule mentioned earlier does not apply to new policies. But you should not be the owner of the policy — that would increase your taxable estate and estate taxes. To keep the death benefits out of your estate, set up an ILIT and have the trustee purchase the policy for you.
1. If Married, Use Both Exemptions
Living Trust with Tax Planning
• Uses both spouses’ estate tax exemptions, doubling the amount protected from estate taxes and saving a substantial amount for your loved ones.
2. Remove Assets From Estate
Make Annual Tax-Free Gifts
• Simple, no-cost way to save estate taxes by reducing size of estate
• $14,000 ($28,000 if married) each year per recipient (amount tied to inflation)
• Unlimited gifts to charity and for medical/educational expenses paid to provider
Transfer Life Insurance Policies to Irrevocable Life Insurance Trust
• Removes death benefits of existing life insurance policies from estate
• Included in estate if you die within three years of transfer
Qualified Personal Residence Trust
• Removes home from estate at discounted value
• You can continue to live there
Grantor Retained Annuity Trust / Grantor Retained Unitrust
• Removes income-producing assets from estate at discounted value
• You can continue to receive income
Limited Liability Company / Family Limited Partnership
• Lets you start transferring assets to children now to reduce your taxable estate
• Often discounts value of business, farm, real estate or stock
• Can protect the assets from future lawsuits, creditors, spouses
• You keep control
Charitable Remainder Trust
• Converts appreciated asset into lifetime income with no capital gains tax
• Saves estate taxes (asset out of estate) and income taxes (charitable deduction)
• Charity receives trust assets after you die
Charitable Lead Trust
• Removes asset from your estate, saving estate taxes
• Income goes to charity for set time period, then trust assets go to loved ones
3. Buy Life Insurance
Through Irrevocable Life Insurance Trust
• Can be inexpensive way to pay estate taxes and/or replace charitable gifts
• Death benefits not included in your estate