You want to do a good thing, leave your loved one not only memories, but money too. However, if your plan is to have them inherit your IRA, it could be costly, if that loved one is someone other than your spouse.
In June the U.S. Supreme Court ruled in Clark v. Rameker, that inherited IRAs are not "retirement funds" within the meaning of bankruptcy law. The translation: they are up for grabs by creditors.
The court distinguished inherited IRAs from a participant-owned IRA because it took into consideration the fact that when you inherit an IRA you can’t make additional contributions, you also must take required minimum distributions no matter your age, and when you inherit an IRA you can withdraw all the money when you want, without penalty. Such rules certainly don’t apply to participant-owned IRAs. The Supreme Court essentially turned positives into negatives.
There are however ways to protect an inherited IRA. The question though, is whether it’s worth doing and what’s involved?
Here are some key considerations
"In the wake of the Supreme Court decision, those that plan to name anyone other than their spouse as their IRA’s primary (or secondary) beneficiary need to consider more sophisticated estate planning arrangements," says ReKeithen Miller, a certified financial planner with Palisades Hudson Financial group.
The most common of which, he says, is having a trust serve as the beneficiary of the IRA. "Naming a trust as your IRA beneficiary is essentially an insurance policy that protects your IRA assets from going to benefit the likes of Visa or MasterCard, instead of your family members," says Miller.
However, you have to weigh the extra protection of a trust against the work and expense of setting up and administering it. Trusts are not cheap. Though costs vary, "To set one up you can expect to pay $3,000-$10,000 in legal fees. There are administrative expenses which can be $2,000-$4,000," says Dean Hedeker, a CPA and attorney with Hedeker Wealth Management Group. Then there is the annual cost to file the trust’s tax return.
There are other concerns besides cost. Choosing the right structure is a challenge, if you’re not being guided by a knowledgeable estate planning attorney or financial advisor. "In order to get all the tax benefits of an inherited IRA coupled with a trust must be a so-called see-through trust, in which the beneficiaries are identifiable under the IRS rules," explains Hedeker.
If there are no identifiable beneficiaries, the IRA funds would have to be withdrawn within five years of the last day of the year the IRA owner died, assuming the IRA owner was younger than 70 ½ years old. If the IRA owner dies at that age, or older, the withdrawals may be based on what would have been the IRA owner’s remaining life expectancy, explains Hedeker.
If the trust isn’t set up as a see-through trust, there could be tax implications. In a non-see-through trust, annual income after the first $12,149 is taxed at the top rate of 39.6%. Income generated in a see-through trust, though, is taxed at the beneficiaries’ individual rate, which probably are a lot lower, says Hedeker.
How else can you protect your heirs?
If trusts sound complicated, they can be. For sure you want good help. There are some other ways to protect your IRA from creditors. Check out the laws in your state. For example, in Ohio, bankruptcy exemption statutes shelter inherited IRAs, points out Chad Lahrmer, CPA and founder of Lahrmer & Company. Other states that have adopted laws expressly exempting inherited IRAs under state bankruptcies include Alaska, Arizona, Florida, North Carolina and Texas, says Mike Kilbourn, author of Disinherit the IRS.
Another strategy says Leonard Rankin, a financial advisor with Park Avenue Securities, "is to withdraw a portion of the IRA while you are alive to buy life insurance on the lives of your children or yourself. After death, when the proceeds are paid, they are creditor proof from the creditors of the heirs in just about all states. Additionally, these funds can be paid to trusts where they would not only be protected, but could also be exempt from estate and inheritance taxes forever."
The bottom line, says Miller, "You have to weigh the extra protection of a trust against the work and expense of setting up and administering it. Establishing a trust and maintaining it can easily cost several thousand dollars a year. If your IRA is only a few thousand dollars, a trust probably isn’t worth the hassle. That’s like paying your auto insurance company premiums to cover a Ferrari when you drive a Ford Fiesta."