One of the biggest estate and financial tragedies is when beneficiaries squander an estate. A loved one spends their entire life accumulating assets and planning ahead to care for their loved ones, they pass on, and within the year all of the assets are lost. While some of it is to taxes, and if the right estate plan wasn’t in place, some of it is certainly to probate attorneys, the vast majority of it is simply spent on frivolous items and vacations. And nowhere is the tragedy deeper than with inherited retirement accounts.
Retirement accounts are a great thing. They allow a person during their working years to put money away for retirement, get a tax deduction when they do, and the assets in the retirement account grow tax-deferred, meaning there are no taxes paid on dividends, interest, or capital gains. However, every dollar that is withdrawn is taxable as income. If withdrawn before retirement age, there are even penalties to pay to the government. But by and large it is a sweet deal because of all of the tax benefits growth.
However, the government is not going to wait forever for their tax money. When a retirement account owner turns 70½, the government mandates that certain portions come out of the account and be taxed as income. Basically, the government looks at life expectancy, sees how many years you supposedly have left, and then calculates a percentage that must come out of your retirement account. Rather than pull out a scientific calculator, books of mortality figures and slide rules, let’s use a very rough outline to illustrate the concept. If you are 71 and life expectancy is 86, you have about 15 years left, at least according to the government tables. This means you would roughly take out 1/15th of your account, and in the next year 1/14th, and so on each year until the account is gone. These are called Required Minimum Distributions. Meanwhile the assets in the retirement account are still growing tax-deferred.
If you run out of time before you run out of retirement account money, then the people you chose inherit your retirement account. What happens then? There are generally three things that can happen. The most common is that a parent passes on, one of their children calls up the company managing the retirement account, and they tell the company that their parent died. The company then instructs the child to send a copy of the death certificate to the company. A few weeks later the beneficiaries get a big check in the mail with a whole bunch of fine print paperwork, and they cash the check figuring they’ll read the papers later. Several months go by, they have a new sports car in the driveway, several rooms in their house remodeled, and a great tan from the 2 weeks they spent on a beach in the Caribbean, and they find out from their accountant that the check they cashed counts as taxable income and the IRS is going to want their tax money.
The second approach has good news and bad news. The good news is that, armed with a bit of knowledge, a beneficiary can do so much more. If instead of depositing the check in the bank the child had gone to their financial advisor they could have set up an Inherited IRA and moved the funds there. This would eliminate the big income tax hit all at once and instead the funds would grow tax deferred over the beneficiary’s lifetime. They would have to take out the same Required Minimum Distributions discussed before, but it would be based on their life expectancy. And not starting at 70½, but right now. Again, using the rough calculations, a 40 year old beneficiary with a life expectancy of 85 would have to take out 1/45th this year, 1/44th the next year and so on. And the rest of the money inside the Inherited IRA grows tax-deferred. In this scenario with a 6% interest rate and an initial Inherited IRA of $500,000, the beneficiary can have more than $1.6 million in distributions over their lifetime rather than losing more than a third of it to taxes right away and not having the benefit of tax-deferred growth.
That is the good news. Here is the bad. About 90% of inherited retirement account money is gone within two years. Why? Even if the beneficiary puts the money into the Inherited IRA, they are not limited to ONLY taking out the required minimum distributions. They can take more. And what happens is that there are emergencies. There’s a Vegas emergency. We have to take the family to Las Vegas for two weeks. Or a Mercedes emergency. The Mercedes is out and we have to get it. Or a Swimming Pool emergency. We need to build an in-ground pool. And before you know it the money, and the benefits of tax-deferred compound growth, are all gone.
There is a third way, and that is establishing an IRA Trust. An IRA Trust is a specific trust designed to comply with IRS regulations to be named as the beneficiary of a retirement account and set up the Inherited IRA for the real beneficiary. The beneficiary of the IRA Trust now has a trustee standing between them and a Caribbean tan telling them that maybe they should hold on to the money for their own retirement. Can the beneficiary get to the money if they have an actual emergency? Of course. But the trustee has to judge whether it is a real emergency or not. And now the $500,000 becoming more than $1.6 million over a lifetime can be a reality and not just numbers on paper that look good.
In order to more fully describe the benefits and requirements of an IRA Trust, I took the time to write the book The IRA Trust, and it will be available through our website at www.livingtrustlawfirm.com/media or on Amazon.com within the week.