Slapping Uncle Sam?s Hand

Nov. 1, 1999
How you can make the most from your IRA and make sure the government isn?t the main beneficiary of your money when you die.

How you can make the most from your IRA and make sure the government isn?t the main beneficiary of your money when you die.

Shannon Evans

It?s a Ocatch 22.O You work hard to fund your retirement so that you and your spouse will be able to live comfortably when you are no longer practicing, or your family will be taken care of in case of a disaster. If that strategy works and you amass a sizeable amount in your IRA and retirement plan, the government will tax up to 80 percent at your death. Damned if you do, damned if you don?t. Is there another option? Yes. The keys are carefully planning the order in which you will Oeat upO your assets at retirement and designating the best beneficiaries for your retirement plan and IRA. A savvy pension-distribution lawyer can accomplish the first planning steps. It is nearly impossible to do it all by yourself. The latter steps are the subjects of this article.

Income tax strategy

Maximizing contributions to your retirement plan is still the very best income-tax strategy. Contributions are made pretax and compound without incurring any income tax until you take out distributions at retirement. Even then, taking out as little as possible will allow the rest to continue compounding and defer income taxes as much as possible. The power of geometric compounding is astounding. Picture this: You and your golfing buddy bet $1 per hole, compounding each hole. The first hole is for $1, the second $2, and so on. At the 18th hole, you will be putting for a whopping

$131,072! Do not make this bet unless you are very sure of your golf game.

The down side is that, at your death, your family may have to pay estate and income taxes on your retirement plan. Again, this can mean the government receives 80 percent of your money. Short of living forever, is there any way out?

The answer is Oyes,O but you must plan carefully now. Your retirement plan and IRA will be included in your estate for determining whether any estate taxes will be due. By combining your unlimited marital deduction (an unlimited amount you can leave your spouse estate tax-free) and your unified credit amount (currently $650,000 that you can pass on to your children estate tax-free), you can minimize estate taxes. A big mistake occurs if your family accidentally takes full distribution of your retirement plan account after your death. This error results in the entire account instantly becoming subject to income tax. Unfortunately, this is a common mistake by the wife and children who are grieving and trying to pick up the financial pieces. The following options can defer income taxes as long as possible:

Strategy 1

In this strategy, we will call the spouse OherO and the retirement plan owner OheO for consistency. Your spouse can take your retirement plan or IRA and Oroll it overO to her own IRA. A spouse can make this election by setting up a special rollover IRA to accept the funds. She cannot transfer these amounts to her own qualified retirement plan. Your spouse can then name your children as new beneficiaries of her rollover IRA. Your spouse can continue the geometric compounding by only taking out the minimum distributions that will be required once she is 701U2. These required minimum distributions can be made as small as possible by basing the amount on the joint life expectancies of your spouse and children. This strategy will defer taxes and maximize the geometric compounding as long as possible. Remember that 18th hole.

Strategy 2

An even better idea is to leave your retirement plan or IRA to your children if your spouse does not need the funds or if you are unmarried. Although your children can never Oroll overO the retirement monies to their own rollover IRAs, they can elect to take out the minimum distributions beginning Dec. 31 in the year after your death, in annual payments over their own life ex-pectancies.

Possible problems with Strategy 2

1. Children blow it all ? Your children could choose to take the entire amount in an immediate distribution and buy Ferraris. Of course, your children are grieving, but the Bahamas would be a good place to do that. Prudence can fly out the window. There is no guarantee that they will have anything left in a year.

2. Court involvement ? If your children are minors and your spouse has died prior to your death, or you are both killed in a simultaneous accident, the court will need to appoint a guardian for your children in order to handle retirement fund distributions. This means unnecessary legal fees and continual court supervision.

3. Lack of skilled advice ? Usually people set up IRAs without any assistance from IRA professionals, such as attorneys or actuaries. This can be a serious mistake, because, typically, major decisions are made when opening an IRA. There are confusing areas that even most skilled professionals do not fully understand, such as designating alternate beneficiaries and choosing a distribution method. Make sure that your adviser has a good grasp of IRA essentials. Ed Slott offers a great monthly newsletter that you or your advisers may enjoy. Call (800) 663-1340 to receive the newsletter.

How can you solve these problems? One way to avoid these pitfalls is to set up a special trust to serve as the designated beneficiary of your retirement plan or IRA for your children. This IBRAT (IRA Beneficiary Restricted Access Trust) is a new type of trust that ensures your children only take out the minimum amount required, or as needed for health or education expenses.

It is entirely separate from your revocable family trust. Have a lawyer draft this type of trust while you are living and list the IBRAT on your beneficiary designation form. The trustee (someone other than you) can regulate payments to your children over a period of time. Your spouse could be the trustee, but be sure to name alternate trustees in case something happens to both of you.

After your death, payments from your retirement plan will be made directly to the IBRAT; then the trustee will make payments to your children. This allows you to minimize income taxes and maximize the compounding of the retirement fund, even after you die. Until your death, the IBRAT is merely sitting empty, waiting to take retirement plan or IRA distributions. At any time before your death, you can change your mind and leave your retirement to your spouse.

Be careful if you change beneficiaries after you turn 701U2, because that could negatively affect your required minimum distributions to yourself during your lifetime. Also be aware that spousal consent will be required if you are designating your children as beneficiaries of your qualified retirement plan. Spousal consent is not necessary for many IRAs, because you already received consent if you rollover a retirement plan to your own IRA.

Remember, you don?t have to let the government take it all. Plan now for your family by minimizing taxes and getting the most tax-deferred growth from your retirement-plan assets. With the use of an IBRAT, you can ensure that the money you worked so hard to save can be a lasting legacy for your loved ones. If you don?t decide now, the government will decide for you at your death.