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Be Cautious When Naming Beneficiaries for Your IRA

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As many readers are aware, IRAs can offer many benefits including the ability to defer taxes on the money placed in the retirement account and possibly to take tax deductions on contributions. But as important as these tax benefits are for the IRA owner, if the designation of IRA beneficiaries is not carefully considered, there may be several unintended consequences…

The Effect on Protection from Creditors

First, here’s how an IRA account owner is protected from creditors: An IRA is protected from most of the retirement account owner’s creditors (except the IRS) in most states. However, if the owner is in bankruptcy, only up to a certain amount is protected ($1,283,015 currently and indexed higher once every three years) if the assets in the IRA have been accumulated from annual contributions to that IRA (whereas rollover IRAs—those rolled over from a 401(k), for instance—have unlimited protection).

In contrast, an inherited IRA is generally not protected from creditors, according to recent court decisions.

This even applies to eligibility for Medicaid. In other words, an inherited IRA may disqualify a beneficiary for Medicaid because the unspent money in the IRA is considered an asset unless it is received and spent down, which can be done by the beneficiary without penalty because it’s an inherited IRA. This easy accessibility may render the IRA vulnerable to creditors.

Here are the court decisions that apply: A recent New York Bankruptcy Court decision, which followed a 2014 Supreme Court decision, held that a beneficiary’s inherited IRA was subject to his creditor’s claims. Although, a few states have recently passed legislation to protect inherited IRAs from the beneficiary’s creditors, the majority of states have not exempted such IRAs. And a recent Eighth Circuit US Court of Appeals decision concluded that an IRA received in a divorce settlement was not a “retirement account” and thus would be available to the debtor’s creditors.

The basis for this distinction, according to these decisions, is that, unlike the original IRA owner, who is subject to penalties for early withdrawals, the beneficiary of an inherited IRA can withdraw any amount without penalty. So if this may be a concern of yours (and one never knows for sure whether a beneficiary will have creditors in the future or which state the beneficiary may reside in at that time), you might want to consider designating a trust as the beneficiary of the IRA.

The Effect on RMDs

IRA beneficiary designations determine how the beneficiary must take annual required minimum distributions (RMDs). If the owner dies after his/her required RMD beginning date (which is April 1 of the year following the year the owner turns 70½) and the beneficiary is an individual other than the spouse, the beneficiary may stretch out the distributions over his life expectancy. (A spouse can opt to roll over the deceased spouse’s IRA into her own IRA).

This can be very important because it allows for the investments to continue to grow tax-free until the required distributions are made. If, for example, a parent designates a child who is 55 as of the end of the year following the parent’s death as the beneficiary of the IRA, that child has 29.6 years to spread out his/her distributions. That would begin with a withdrawal in the first year of just 1/29.6 of the IRA’s prior year-end balance (see IRS Publication 590, Appendix B, Table 1). Each year thereafter, the denominator of the fraction is reduced by one, meaning the proportion increases.

If, instead, the parent designates multiple beneficiaries, each of them will have to use the oldest beneficiary’s age for purposes of computing the RMD unless each sets up his own inherited IRA before December 31 of the year following the year of death. If a child will not likely need the IRA funds for his own support, consideration should be given to designating a grandchild who would be able to stretch out the distributions over a much longer period (that is, a 10-year-old would have 72.8 years to stretch out the distributions).

As noted above, if the owner wishes to ensure that the IRA will be protected from the beneficiary’s creditors, he would be well advised to designate a trust as a beneficiary. However, in order to obtain the “stretch-out” benefit described above, the beneficiary must be identifiable—that is, an individual whose age can be determined under the terms of the trust agreement. Although the rules can be complex, suffice it to say that if the designated beneficiary is a trust, then a stretch-out will not be permitted (and the IRA must be distributed within five years of the death) unless the trust is drafted either as an “accumulation trust” or a “conduit trust.”

If a trust is designated as the beneficiary, one must review carefully the distribution provisions contained in the trust agreement. If, for example, the trust provides for the assets to be distributed in the trustee’s discretion among a class of persons, without any provision for mandatory annual distributions, then the age of the oldest beneficiary in the class will determine the RMD amount. If, however, the class includes possible distributions to charities, it will disqualify the IRA from stretching out the distributions and the entire account would be required to be distributed within five years.

A conduit trust requires the trustee to distribute, at a minimum, the RMD amount to the beneficiary each year. Where it may not be in the beneficiary’s best interest to receive an annual distribution (for example, if the beneficiary has a substance-abuse problem), an accumulation trust may be a better option. In this trust, the trustee must receive the RMD from the IRA account but may accumulate it in the trust instead of disbursing it out each year to the beneficiary.

As IRA and other retirement accounts can make up a significant portion of one’s net worth, it is increasingly important to seek competent professional advice to minimize the potentially adverse consequences of making the wrong decision.

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