How income tax_eats_an_exploded_ira

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How income tax_eats_an_exploded_ira

  1. 1. The IRA Protection Trust How to Protect Your IRA Account For Your Beneficiaries from: Excessive Inheritance tax Excessive Income tax Divorce or Creditors Mistakes in “Exploding” the IRA Law Offices Tom Sammons 502 N. Plum Grove Rd. Palatine IL 60067 [email_address] www.lawsam.com 847-359-9610
  2. 2. Facts about IRA accounts <ul><li>IRA accounts began in 1974; they are now more than 31 years old </li></ul><ul><li>There is more than $3.0 trillion invested in IRAs, representing 26% of all retirement dollars </li></ul><ul><li>40% of US households have IRAs </li></ul>
  3. 3. Nothing is Forever <ul><li>Money was never meant to be left in IRA accounts “forever.” But there is an effective and legal way to “stretch out” distributions for your beneficiaries as long as possible after the IRA owner’s death and keep income taxes as low as possible. </li></ul><ul><li>( A note on 401ks : This does not apply to 401k accounts. If you leave a job, you should roll over your 401k to an IRA account immediately - if not sooner. There is no reason, ever, under any circumstance, to leave a 401k account with a former employer). </li></ul>
  4. 4. <ul><li>This discussion applies to those who have an IRA account of about $250,000.00 or more. </li></ul><ul><li>It explains with how best to designate the beneficiary of your IRA account so that after your death: </li></ul><ul><li>the least income tax is paid </li></ul><ul><li>the least inheritance tax is paid </li></ul><ul><li>the IRA account remains free of the claims of creditors and divorce </li></ul><ul><li>-the IRA account remains in your family </li></ul>
  5. 5. IRA accounts are pretty simple while you are alive . <ul><li>IRA accounts grow “tax deferred,” meaning they are not subject to income tax while you are alive, unless you take a distribution. Distributions must be taken starting by April 1 of the year AFTER you turn 70.5 years old. </li></ul>
  6. 6. Things can get a little messy when the IRA account owner dies <ul><li>IRA “Explosion” </li></ul><ul><li>This happens if no beneficiary is designated for the IRA. “Explosion” means that income tax is due on the ENTIRE IRA account. </li></ul><ul><li>“ Explosion” also happens if a child, named as beneficiary, withdraws all funds from the IRA either because of financial pressures or lack of knowledge about the subject. A spouse of the child-beneficiary sometimes will influence the child to withdraw IRA funds for vacation, home remodeling etc. </li></ul><ul><li>“ Explosion” also happens when a named beneficiary tries to “roll over” your IRA to his or her own IRA—you can’t do that (unless you are a spouse). </li></ul><ul><li>Income tax of up to 35% will be due when the funds are withdrawn. </li></ul>
  7. 7. Problems with Making a Child/Heir direct beneficiary of IRA <ul><li>Beneficiary may become disabled or may be receiving Social Security Disability (SSI). Government benefits are lost because they inherited the IRA. </li></ul><ul><li>The IRA adds to the estate of the beneficiary increasing their inheritance taxes. Will your child/heir have the foresight to plan so that the IRA is not subject to estate taxes at all? </li></ul><ul><li>In Illinois, life insurance, annuities and--you guessed it—IRAs, cannot be taken by a creditor. But, what if your child/heir withdraws funds from the IRA? The funds are then subject to the claims of creditors. Why risk that you child/heir will “explode” the IRA and then let a creditor get the rest? </li></ul><ul><li>If a child inherits an IRA and withdraws all of the funds from the IRA, and then later is divorced from their spouse, the funds will be divided “equitably” in the divorce case. Usually, this means a 50/50 division. The divorce rate has actually dropped in recent years to about 38% (you often hear 50%), but it remains a concern for the parents of adult children. Wouldn’t it be nice to have a divorce-proof way to handle IRA funds after you are gone? </li></ul>:
  8. 8. Traditional ways of handling the beneficiary of your IRA <ul><li>Designate spouse as beneficiary then kids . This works fine with small estates and in cases where the kids have small estates and are healthy and financially competent. </li></ul><ul><li>Designate the living trust as beneficiary . The IRA custodian rarely understands this option. Clients have an even harder time with this option. This may be the only option if one spouse has a large IRA ($1 million or more) and all other assets are in the other spouse’s living trust. Problem : Money must come out of the IRA, and income tax must be paid on the money, too quickly. Usually the surviving spouse’s life expectancy will be used for distributions from the IRA, rather than the kid’s life expectancies. </li></ul><ul><li>No beneficiary - In my experience this happens about 40% of the time. All funds must be withdrawn from the IRA and income tax paid within a short period, many times 5 years or less. </li></ul><ul><li>Generally, we try to minimize inheritance taxes on IRA accounts. We also try to stretch out distributions from the IRA as long as possible to reduce income taxes. Third, we try to protect the client’s assets from divorce and creditors. </li></ul><ul><li>These methods do a so-so job at these tasks. </li></ul>
  9. 9. <ul><li>Is there a better way to inherit an IRA? </li></ul>
  10. 10. The IRA Protection Trust What will this trust do for me? <ul><li>Keeps income taxes as low as possible on the IRA </li></ul><ul><li>IRA funds will continue to grow tax-deferred </li></ul><ul><li>IRA distributions can be “stretched out” as long as the law allows </li></ul><ul><li>IRA will be protected from Divorce and Creditors </li></ul><ul><li>Disabled child will still be eligible for government benefits even if IRA is inherited </li></ul><ul><li>You can “lock in” the end beneficiary of the IRA </li></ul>
  11. 11. How does it work? <ul><li>My office prepares an IRA Protection Trust for the client. </li></ul><ul><li>The client is usually the trustee </li></ul><ul><li>The client picks back-up trustees to manage the IRA funds after death </li></ul><ul><li>The IRA Protection Trust can be changed or amended whenever the client desires </li></ul><ul><li>Beneficiary change forms are completed to be consistent with the trust. </li></ul><ul><li>Later, upon the client’s death, the IRA is split into Separate Accounts for each beneficiary. </li></ul><ul><li>In the example below, upon the client’s death, a $500,000 IRA is divided into 3 separate shares for two children and a grandchild. </li></ul>
  12. 12. Each Child Can withdraw Based on their Age . Each beneficiary can use his or her own life expectancy to take withdrawals from the IRA. For example, Child 1 is 40 years old, he can take 1/44 out of the IRA the year after the client’s death (and pay income taxes on the 1/44th) and rest of the account would continue to grow tax deferred. Turn on and off distributions. The trustee can turn on and off distributions from the IRA as the need arises. Child 2 became disabled and had little in other funds, so the trustee of the IRA Protection trust was able to “turn off” distributions from the IRA, but the IRA money continues to accumulate for Child 2 in the trust . Client’s $500,000.00 IRA $166,666 Child 1 40 yrs old $166,666 Grandchild 1 18 years old $166,666Child 2 30 yrs old Passes to kids of Child 1 on Child 1’s death (not spouse) - This is “ locked in” Child 1 has a large estate of her own. The IRA is free of estate taxes-saving her a substantial amount of estate tax Grandchild 1 is divorced after Client’s death- The IRA is protected in the divorce Distributions to Child 2 are stopped by the trustee (but money continues to accumulate in the trust) because he becomes disabled and receives Social Security Disability (SSI) - Later, distributions restart when SSI is not needed.
  13. 13. Locking in the Beneficiary . The client was concerned that Child 1’s spouse was to “pushy” and that he would influence the beneficiary choice, so the Client “locked in” the end beneficiaries to be the children of Child 1 (making sure the spouse did not end up as an accidental or intentional beneficiary) No estate taxes on funds in IRA Protection Trust. The money in the IRA Protection Trust is not taxed in the estate of the beneficiary. (The IRA is included in the estate of Client). For beneficiaries with large estates, this is a major benefit. Divorce Protection . Grandchild 1 is younger than the other two. She can take distributions from the IRA using her life expectancy. She is divorced at a young age, but the IRA is in the IRA Protection Trust, so it is not dragged into the divorce. Client’s $500,000.00 IRA $166,666 Child 1 40 yrs old $166,666 Grandchild 1 18 years old $166,666Child 2 30 yrs old Passes to kids of Child 1 on Child 1’s death (not spouse) - This is “ locked in” Child 1 has a large estate of her own. The IRA is free of estate taxes-saving her a substantial amount of estate tax Grandchild 1 is divorced after Client’s death- The IRA is protected in the divorce Distributions to Child 2 are stopped by the trustee (but money continues to accumulate in the trust) because he becomes disabled and receives Social Security Disability (SSI) - Later, distributions restart when SSI is not needed.
  14. 14. Benefits of Tax Deferral inside the IRA Protection Trust
  15. 15. How Income Tax Eats an “Exploded” IRA Brown area is Income taxes paid. More than $166,000.00. No immediate income tax on IRA Protection Trust
  16. 16. Growth of “Exploded” IRA over 20 years 20 years later: $335,000 “exploded” account grows to $736,855 - Pretty Nice…huh
  17. 17. Even Bigger Growth with IRA Protection Trust <ul><li>The total after tax benefit of the IRA Protection trust over 20 years is $1,206,399.00 </li></ul>
  18. 18. <ul><li>A recent 2005 Private Letter ruling by IRS authorized this type of trust </li></ul><ul><li>IRS liberalized IRA rules in 2002 and made IRA trusts possible </li></ul>Why have I never heard of this? My busy-body neighbor doesn’t know about these trusts—and he knows everything.
  19. 19. Pros -Summary- Cons <ul><li>Protects kids/heirs assets from lawsuit/creditors even if laws change </li></ul><ul><li>Protects IRA from kids/heirs divorce </li></ul><ul><li>Protects IRA from kids/heirs “explosion” of IRA by unintentionally mishandling it </li></ul><ul><li>No estate tax on IRA (in kids/heirs estate) </li></ul><ul><li>Locks in tax deferred growth for years </li></ul><ul><li>Easy to amend/change </li></ul><ul><li>IRA is protected from meddling in-laws </li></ul><ul><li>Difficult to leave IRA to spouse and then stretch it out with IRA Protection Trust. (Consider life insurance for spouse-IRA to kids in IRA Protection Trust) </li></ul><ul><li>Cost of setting up trust </li></ul><ul><li>Need trustee to manage IRA Protection Trust </li></ul>

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