How To Inherit An Ira Trustee

Transcription

1 Tenth Floor Columbia Center 101 West Big Beaver Road Troy, Michigan (248) Fax (248) SPECIAL REPORT THE IRA BENEFICIARY DESIGNATION FORM: HOW TO COMPLETE IT PROPERLY By Salvatore J. LaMendola, J.D., C.P.A. 1. Understand the importance of the form. Your IRA beneficiary designation form ( BDF ) governs the division and distribution of your IRA after you pass away. The BDF trumps all provisions in your Will and in your Living Trust. 1 Because the BDF often governs more assets than either your Will or your Living Trust, you should think of your BDF as your second Will. Example: Amy has a $100,000 home, a $50,000 taxable investment account, and a $450,000 IRA (payable to her son). Amy s BDF governs 75% of the total value of her estate ($450,000/ $600,000). Amy decides that she no longer wishes her son (and only child) to inherit her estate. Therefore, she amends her Living Trust accordingly. This takes care of the 25% that is governed by the Living Trust, but not the IRA. Amy must also amend her BDF to handle that. If she fails to do so, her son will still inherit 75% of her total assets at her death. 2. Anticipate the possibility of a predeceased beneficiary. Anticipating and addressing the unlikely events, such as a predeceased beneficiary, is the mark of good planning. A per stirpes designation (or default provision in the IRA agreement) will allow a predeceased beneficiary s heirs to inherit his/her share. A per capita designation (or default provision) will allow the other beneficiaries to inherit the share, either equally or in the same proportions as they inherited their own shares (called pro rata ). 2 Since practically all default provisions are per capita (see Table I below), if you want a predeceased beneficiary s heirs to inherit his/her share, you must indicate per stirpes on your BDF. Example: Jack names his three daughters Margo, Marcy, and Monica as 1/3 beneficiaries of his $300,000 IRA. Each daughter has two children of her own. If a daughter predeceases him, Jack wants her share to pass equally to her children (i.e., $50,000 to each grandchild). Jack and Marcy are in a car accident. Marcy dies instantly. Jack dies a week later. Margo and Monica inherit $150,000 each and Marcy s children inherit nothing. Why? Because Jack failed to indicate per stirpes for Marcy s share on his BDF. 1 Assuming that you have not named your estate, which is governed by your Will, or your Living Trust as the beneficiary of your IRA. 2 For example, if the designation is of A for 50%, B for 30%, and C for 20%, and if B predeceases, then A and C will receive 65% and 35%, respectively, if per capita (equal) applies, or 71% and 29%, respectively, if per capita (pro rata) applies. On the other hand, A and C will receive 50% and 20%, respectively, if per stirpes applies, with the remaining 30% going equally to B s children. COPYRIGHT 2012 SALVATORE J. LAMENDOLA, J.D., C.P.A.

2 2 TABLE I SUMMARY OF DEFAULT PREDECEASED BENEFICIARY PROVISIONS IRA Provider 3 Per Stirpes Per Capita (Equal) Charles Schwab Edward Jones Fidelity Merrill Lynch Morgan Stanley Smith Barney Raymond James TD Ameritrade UBS Vanguard Wells Fargo Per Capita (Pro Rata) 3. Name successor beneficiaries. The original beneficiary is the beneficiary who actually inherits. This could be the primary beneficiary, if he or she survived you, or the contingent beneficiary, if the primary beneficiary predeceased you. The successor (or remainder ) beneficiary inherits after the original beneficiary dies. Example: Clifford wants his second wife, Jennifer, to inherit his IRA if she survives him. He therefore names Jennifer as the primary beneficiary of his IRA. If Jennifer predeceases Clifford, then Clifford wants Reginald, his son by his first marriage, to inherit the IRA. He therefore names Reginald as the contingent beneficiary. If Jennifer survives Clifford, and if there is a balance left in the IRA at Jennifer s death, then Clifford wants Reginald to inherit that balance at that time. He therefore also names Reginald as the successor beneficiary of his IRA. Many custodial IRAs do not allow you to name successor beneficiaries. In that case, if the original beneficiary dies without having named a successor beneficiary, the default provisions will name one for him/her (see Table II below). A trusteed IRA will allow you to name successor beneficiaries, but these IRAs have other drawbacks. 4 As a result, using a custom drafted trust as the beneficiary of a custodial IRA is usually the best option. 3 Inclusion is for illustration only and not an endorsement. 4 The drawbacks of trusteed IRAs include the inability of the beneficiary to move to a different IRA provider, potentially higher fees, potentially narrower investment choices, the inability to use an individual (such as a family member) as trustee, the inability to stop all distributions to a spendthrift beneficiary, and the inability to include customized provisions. On the other hand, trusteed IRAs avoid the complicated IRS requirements that must be met for custom drafted trusts to work and the legal fees for drafting them. They also eliminate the cost of preparing annual post-death trust income tax returns (IRS Form 1041).

3 3 Example: Owen named his son, Parker, as the primary beneficiary of his IRA. He named Parker s son, Chester, as the contingent beneficiary. Five years after Owen s death, Parker dies with no successor beneficiary named. Therefore, Susan, Parker s second wife (Chester s stepmother) inherits the IRA next. How? First, since Parker survived Owen, Chester was eliminated as a beneficiary completely. Next, since Parker did not re-name Chester (or anyone else) as successor beneficiary, the default provision controlled. It named Parker s estate. Finally, since Parker s Will left his entire estate to Susan, the balance of the IRA is Susan s. 5 If, in addition to naming Chester as the contingent beneficiary, Owen had also named Chester as the successor beneficiary (or if Owen had used a custom drafted trust), Chester would have inherited the IRA next, not Susan. 6 IRA Provider Charles Schwab Edward Jones Fidelity Merrill Lynch Morgan Stanley Smith Barney Raymond James TD Ameritrade UBS Vanguard Wells Fargo TABLE II SUMMARY OF DEFAULT SUCCESSOR BENEFICIARY PROVISIONS Estate then Children, then Children, then Parents, Language to look for: Unless a designation filed by the Depositor and agreed to by the Custodian states otherwise, if the Beneficiary dies after the Depositor, the beneficiary will be the person, persons, legal entity or entities designated by the Beneficiary Specify the manner of distribution. Silence allows your beneficiary to withdraw the entire IRA all at once (called a cash-out ). This results in the immediate income taxation of the entire distribution 8, usually at higher income tax rates because of bracket creep. 9 5 If Parker died intestate (without a Will), under most intestacy statutes, Susan would still inherit at least 50% of the IRA. 6 This assumes that Parker (or Susan acting as Parker s agent under a DPOA - more at item 10 below) would not have substituted Susan for Chester after Owen s death. With a custom drafted trust, this could not happen. Without one, it could. 7 From the Wells Fargo custodial IRA agreement. Emphasis added. However, even if the emphasized language is used to prevent the original beneficiary s changing the original successor beneficiary, the change could nonetheless be accomplished by a transfer to a different IRA provider. This could not happen if a trusteed IRA or custom drafted trust were used. 8 Here and throughout, if a Roth IRA is involved, growth within the Roth IRA and distributions from it are tax-free. 9 For example, in 2012 a single taxpayer is taxed at 28% on taxable income between $85,651 and $178,650; at 33% on taxable income between $178,651 and $388,350; and at 35% on taxable income in excess of $388,350. COPYRIGHT 2012 SALVATORE J. LAMENDOLA, J.D., C.P.A.

4 4 Cash-outs also forfeit all future tax-deferred growth. By limiting a beneficiary to annual required minimum distributions ( RMD s) which are taken over the beneficiary s life expectancy (called a stretch-out ), the beneficiary inherits more. Example: Robert inherits a $300,000 IRA when he is age 44. If Robert stretches-out and reinvests each RMD in a taxable investment account, how much more will be in that account than if Robert had cashed-out and reinvested? The following schedule illustrates the stretchout advantage at various rates of return. 10 Capital Stretch-Out Cash-Out Income Gain Rate Total Account Account Stretch-Out Rate of Return of Return Return Balance Balance Advantage 2% 2% 4% $ 921,303 $ 708,927 $ 212,376 2% 3% 5% 1,344,121 1,017, ,496 2% 4% 6% 1,954,212 1,455, ,309 2% 5% 7% 2,831,582 2,076, ,417 2% 6% 8% $ 4,089,189 $ 2,951,216 $ 1,137,972 Most IRA agreements allow stretch-outs by beneficiaries, but most will not allow a mandated one. 11 Even if the IRA agreement allows a mandated a stretch-out, the beneficiary could get around it by first moving the IRA to a new IRA provider, and then cashing-out. Trusteed IRAs allow mandated stretch-outs, but they have other drawbacks. 12 As a result, using a custom drafted trust as the beneficiary of a custodial IRA is usually the best option. In fact, if you do not want a beneficiary to automatically receive each RMD (for greater creditor protection, generation skipping tax planning, or other reasons), then using a custom drafted trust as the beneficiary of a custodial IRA is the only option. Language to look for: You may restrict a beneficiary from taking distributions in excess of specified amounts, although these distributions must at least equal required minimum distributions Appoint an investment advisor. As seen above, the stretch-out opportunity can provide significant economic benefits to heirs. But consistent, positive investment returns are also required. For that reason, arrange for your investment advisor to continue getting good returns for your heirs. 10 Assumptions: 28% income tax rate (except for 35% income tax rate on cash-out due to bracket creep ); 15% capital gains tax rate (25% of capital gains realized annually); All income and capital gains taxes paid from the investment account; All earnings in the investment account also reinvested; 39-year stretch-out period. 11 Do not assume that your IRA agreement allows stretch-outs. Instead, check to be sure. 12 See note 4 above. 13 From the Merrill Lynch custodial IRA agreement.

5 5 Some custodial IRA agreements allow this, but even those that do could be circumvented either by a move to new IRA provider or by a beneficiary s right to name his or her own investment advisor after you die. Trusteed IRAs can avoid those problems, but they have other drawbacks. 14 As a result, a directed trust arrangement 15 with a custodial IRA is often the best option. Example: Sandra freely admits that because of Laura, her investment advisor, Sandra s traditional IRA is her most valuable asset - by far. Though Sandra s time is now short due to advanced illness, she is comforted to know that her grandchildren will each enjoy at least 50 more years of continued tax-deferral through the custom drafted trusts that Sandra has set up for them. In fact, because the RMDs will be so small at the start, the IRA will actually increase in value post-death, if good investment returns are obtained. To ensure that they are, Sandra designates Laura as the investment advisor to the trustee of each trust. This means that Laura continues to manage the IRA portfolio after Sandra s death, not the trustee. Thus, Sandra s grandchildren will not only inherit Sandra s most valuable asset, but also her most valuable advisor. Language to look for: The Investor or, following his or her death, the Beneficiary, shall be permitted at all times to direct, or retain an agent, investment advisor, or manager to direct the Custodian as to the investment or reinvestment of the assets of the Account Confirm that separate accounts are allowed. If post-death separate accounts are timely established, the IRS s separate accounts rule will allow younger beneficiaries to use their own life expectancies and therefore inherit more by taking longer stretch-outs. But just because the IRS allows this doesn t mean that your IRA agreement does. Example: Brian (age 45) and Baxter (age 42), inherited a $500,000 IRA in Year 1. If separate accounts are allowed under the IRA agreement, if those accounts are established by December 31, Year 2, if the IRA grows at 6% per year, and if Brian and Baxter take RMDs only, then they would receive $944,215 and $1,054,544 in cumulative pre-tax distributions, respectively. However, because the IRA agreement does not allow separate accounts, Baxter must use Brian s shorter life expectancy. This costs Baxter $110,329 ($1,054,544 - $944,215) pre-tax. To take advantage of the separate accounts rule when individuals and non-individuals (such as charities) are beneficiaries, use fractional formulas for fixed-dollar (or pecuniary ) bequests. 14 See note 4 above. 15 A directed trust arrangement is an arrangement within a custom drafted trust that places the investment function with your investment advisor, not the trustee. The trustee of the trust still performs the other trustee functions (such as withdrawing RMDs and distributing them to the beneficiary, filing tax returns, etc.). But when it comes to how to invest the IRA, the trustee must follow your investment advisor's directions. 16 From the Vanguard custodial IRA agreement. COPYRIGHT 2012 SALVATORE J. LAMENDOLA, J.D., C.P.A.

6 6 Model Provision 17 : Instead of this: I hereby designate ABC Charity as the beneficiary of $50,000 of my IRA, and I designate my descendants who survive me, per stirpes, as the beneficiaries of the balance of my IRA. Use this: I hereby designate ABC Charity as the beneficiary of a fractional share of my IRA with the numerator of the fraction being $50,000 and the denominator of the fraction being the value of my IRA on the date of my death. I designate my descendants who survive me, per stirpes, as the beneficiaries of the balance of my IRA. To take advantage of the separate accounts rule with trusts, name the testamentary subtrusts to be created under a revocable living trust instead of the revocable living trust itself. Model Provision: Instead of this: I hereby designate the trustee of the John Doe Revocable Living Trust, u/a/d as the beneficiary of my IRA. Use this: If at least one of my descendants survives me, then divide my IRA into separate shares for my descendants who survive me, per stirpes. I hereby designate the trustee of the trust established for my descendant under Article of the John Doe Revocable Living Trust, u/a/d as the beneficiary of that descendant s share of my IRA. If none of my descendants survive me, then I designate ABC Charity as the beneficiary of my IRA. Language to look for: If you name more than one primary beneficiary of your IRA, upon your death, your IRA will be divided into separate shares and each beneficiary s share will be segregated into a separate account Confirm portability. The direct (or trustee-to-trustee ) transfer is the only IRS-approved way that a non-spouse beneficiary can move an inherited IRA to another IRA provider. 19 This may be desirable if a competing IRA provider charges lower fees, offers better investment options, or allows payment of wrap fees 20 from non-ira (or outside ) assets. But just because the IRS allows direct transfers doesn t mean that your IRA agreement does. Example: Stacey (age 50) inherited a $500,000 IRA from her aunt. Knowing that contributions to inherited IRAs are prohibited, but also knowing that the IRS does not consider payment of separately billed wrap fees from outside assets to be prohibited contributions, Stacey would like to move her inherited IRA to an IRA provider that permits such payment. By doing so, she will keep more invested tax-deferred longer. (In addition, she may also be able to deduct the wrap fees paid.) However, Stacey is disappointed to learn that her aunt s IRA provider not only prohibits the payment of wrap fees from outside assets, but it also prohibits portability. Assuming a 1% annual wrap fee and a 6% annual rate of return, this costs Stacey $208,836 in cumulative pre-tax distributions and $97,101 in potential tax deductions over the 35-year stretch-out period. 17 This and all other model provisions are for illustration only. 18 From the Morgan Stanley Smith Barney custodial IRA agreement. 19 The inherited IRA remains an inherited IRA with the new provider. 20 Wrap fees are fees that are calculated as a percentage of the value of the IRA and do not vary depending on the number or type of transactions in the IRA.

7 7 Language to look for: Alternatively, but only with the consent of the Custodian, fees and expenses may be paid directly to the Custodian by the Depositor (the Authorized Agent, or, following the death of the Depositor, the Beneficiary) by separate check Use the right language when naming trusts. If the trust is for the life of only one person, to avoid post-death complications, make the trust s status as a beneficiary conditional on the trust beneficiary s survival. Model Provision: Instead of this: I hereby designate the trustee of the Marital Trust established under Article of the Jane Doe Revocable Living Trust, u/a/d as the beneficiary of my IRA. Use this: If my spouse survives me, then I hereby designate the trustee of the Marital Trust established under Article of the Jane Doe Revocable Living Trust, u/a/d as the beneficiary of my IRA. If my spouse does not survive me, then I designate my descendants who survive me, per stirpes, as the beneficiaries of my IRA. If the trust will terminate upon a specified event (such as the trust beneficiary s attaining a certain age), to avoid post-death complications, make the trust s status as a beneficiary conditional on the non-occurrence of the event. Model Provision: Instead of this: I hereby designate the trustee of the John Doe Irrevocable Trust f/b/o James Doe, u/a/d as the beneficiary of my IRA. Use this: If my son, James Doe, survives me, and if he is under age 50 at the time of my death, then I hereby designate the trustee of the John Doe Irrevocable Trust f/b/o James Doe, u/a/d as the beneficiary of my IRA. If my son, James Doe, survives me, and if he is not under age 50 at the time of my death, then I designate my son, James Doe as the beneficiary of my IRA. If my son, James Doe, does not survive me, then I designate ABC Charity as the beneficiary of my IRA. A uniform transfer to minor s act account (UTMA) until age 21 may be a good alternative to a trust where smaller IRAs are involved. Model Provision: Instead of this: I hereby designate my granddaughter, Jane as the beneficiary of my IRA. Use this: If my granddaughter, Jane, survives me, and if she is under age 21 at the time of my death, then I hereby designate my son, Robert, as custodian for Jane until age 21, under the [Name of State] Uniform Transfer to Minor s Act, as the beneficiary of my IRA. If my granddaughter, Jane, survives me, and if she is not under age 21 at the time of my death, then I designate Jane as the beneficiary of my IRA. If my granddaughter, Jane, does not survive me, then I designate my son, Robert, as the beneficiary of my IRA. 21 From the Fidelity Investments custodial IRA agreement. COPYRIGHT 2012 SALVATORE J. LAMENDOLA, J.D., C.P.A.

8 8 9. Anticipate the possibility of a disclaimer. Contingent beneficiaries receive whatever a primary beneficiary disclaims (chooses not to inherit). 22 However, sometimes the disclaimer contingent beneficiaries should be different from the death contingent beneficiaries. Example: Cecile named her wealthy son, Walter, as the primary beneficiary of her $700,000 IRA. She named Walter s children as the contingent beneficiaries. After Cecile s death, Walter decides that he would prefer to donate the IRA to charity. If Cecile had anticipated this, she could have arranged it so that with Walter s disclaimer, the IRA would have passed directly to charity. However, because she did not, the IRA can only pass indirectly to charity. This means that Walter must first cash-out the IRA, pay all the estate and income taxes on it, and then donate the balance to charity 23. Model Provision: Instead of this: I hereby designate my son, Walter, as the primary beneficiary of my IRA and my grandchildren who survive me as the equal contingent beneficiaries of my IRA. Use this: I hereby designate my son, Walter, as the primary beneficiary of my IRA and my grandchildren who survive me as the equal contingent beneficiaries of my IRA; provided, however, that I designate ABC Charity as the beneficiary of any fractional share (or all) of my IRA that my son, Walter, disclaims Keep a copy of the BDF and the IRA agreement too. Keeping a copy of the BDF is essential. The IRA provider s receipt and acceptance of the BDF should be indicated on the form itself. Since the IRA provider is bound to honor the default provisions contained in the IRA agreement that you signed, and not a later version of the same, to avoid post-death confusion, keep a copy of your signed IRA agreement too. Example: After his death, Lyle s BDF could not be found. Assuming that its current IRA agreement (which defaulted to the estate) controlled, Lyle s IRA provider told Gayle, Lyle s widow and the executor of Lyle s estate, that after she obtained letters of authority from the local probate court, distribution could be made to the estate, but that Gayle could not then roll the distribution over to her own IRA (called a spousal rollover ). However, after much searching, Gayle found the IRA agreement that Lyle had signed. That prior version defaulted to the surviving spouse (see Table III below). As a result, the spousal rollover was saved and a probate proceeding avoided. 22 This is because the primary beneficiary is treated as having predeceased the IRA owner with respect to the portion disclaimed. 23 Hopefully, Walter picks a charity that Cecile would have approved. 24 In general, the use of a private foundation as a disclaimer beneficiary is ill advised because the disclaiming beneficiary cannot be a trustee of the same. A donor advised fund is a better alternative because the disclaiming beneficiary can be an advisor to such a fund.

9 9 TABLE III SUMMARY OF DEFAULT DISTRIBUTION PROVISIONS IF NO BDF IS FILED OR IF NO BENEFICIARY SURVIVES THE ORIGINAL IRA OWNER IRA Provider Charles Schwab Edward Jones Fidelity Merrill Lynch Morgan Stanley Smith Barney Raymond James TD Ameritrade UBS Vanguard Wells Fargo 11. Be sure to sign a DPOA. Estate then Children, then Children, then Parents, If you are disabled, a durable power of attorney (DPOA) will allow your agent (or attorney-in-fact ) to handle your IRA for you. 25 The DPOA should authorize your agent to create new IRAs in your name. It should also give your agent the authority to invest, contribute to, withdraw from, and roll over your IRAs. If you are married, the DPOA should allow spousal rollovers. Giving authority to recharacterize Roth IRA conversions is also advisable. The DPOA should allow your agent to designate the beneficiaries of new, rollover, recharacterized, and inherited IRAs, all according to how you specify. Example: Albert named his wife, Carole, as the primary beneficiary of his IRA and his three children as the contingent beneficiaries of the same. At the time of Albert s death, Carole is disabled. Therefore, Carole s son, Tim, acting as Carole s agent, establishes a spousal rollover IRA in Carole s name. As part of that process, Tim learns that he cannot name himself and his siblings as the primary beneficiaries of the same. This is because Carole s DPOA did not explicitly authorize Tim to do so. Carole dies two weeks later, with no beneficiaries named. Since the default provision is to Carole s estate, Tim s and his siblings stretch-outs are lost. 25 In addition to having a DPOA, find out whether your IRA provider will honor it. Often, IRA providers will only honor DPOAs created on their own forms. If this is your IRA provider s policy, find out now, while you are still legally able to sign their form, rather than later, when you may not be. COPYRIGHT 2012 SALVATORE J. LAMENDOLA, J.D., C.P.A.

10 10 If charitable giving is anticipated, such as by QCDs 26 or by testamentary charitable bequests, the DPOA should anticipate the same. Model QCD provision for DPOA: I authorize my agent to make qualified charitable distributions (within the meaning of Section 408(d)(8) of the Internal Revenue Code) from my traditional IRA to any charity that I have regularly given to in the past, giving preference to satisfying any charitable pledges that are still outstanding. Model Testamentary Charitable Bequest provision for DPOA: I direct my agent to designate my charitable foundation as the sole primary beneficiary of all of my traditional IRAs. In so doing, my agent should indicate my foundation as follows: The trustee of the Susan N. Smith Private Foundation u/a/d (EIN ) Review and update your BDF regularly. As mentioned at the start, your IRA BDF is your second Will. It should therefore be reviewed at least as often as you review your other estate planning documents (once a year recommended). Your BDF should also be reviewed when life events occur (such as births, deaths, marriages, or divorces) and when the tax laws change. Example: David, age 50 and without children or siblings, named his mother as the primary beneficiary of his $850,000 IRA. After their marriage, David and his new bride, Judy, updated their estate planning documents accordingly. However, David s BDF was overlooked. As a result, upon David s unexpected death a year later, Judy is shocked to discover that her mother-in-law inherits her deceased husband s IRA, not her! 26 For donors age 70½ and older, paying up to $100,000 from an IRA directly to a qualified charity is a Qualified Charitable Distribution ( QCD ) that will prevent the amount transferred from being taxed. The QCD amount will also be credited toward an RMD obligation. Though now expired, this tax break will likely be extended sometime in This assumes that the foundation was organized as a trust. If it was organized as a not for profit corporation, then substitute the following: The Susan N. Smith Private Foundation, a [Name of State] not for profit corporation (EIN ). This Special Report is designed to provide accurate (at the time of printing) and authoritative information with regard to the subject matter covered. It must not be used as the basis for legal or tax advice. In specific cases, the parties involved must always seek out and rely on the counsel of their own advisors. Thus, responsibility for modifying and guiding any party s action with respect to legal and tax matters is placed where it belongs with his or her own advisors. TO THE ETENT THIS BROCHURE CONTAINS TA MATTERS, THIS BROCHURE IS NOT INTENDED NOR WRITTEN TO BE USED AND CANNOT BE USED BY A TAPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAPAYER, ACCORDING TO CIRCULAR 230.