02 Nov Stretch Your IRA – The “Third Option”
After the initial surprise of being told they have inherited a traditional IRA account from a parent or other grantor, some beneficiaries are later surprised again to discover they have to pay federal income tax on the full amount of the inherited IRA. Some relief is granted by the IRS by allowing each beneficiary an election to defer the distribution and related income tax arising from the distribution under the five (5) year rule1 or the life expectancy of the deceased IRA owner2. The shame is that the tax deferral could have been significantly stretched out further over the beneficiaries’ life had the deceased IRA owner chosen to contemplate the needs of his or her beneficiary and establish an IRA Inheritance Trust or trust provision; the “Third Option”. Consider the following example of the additional growth that could be enjoyed by a family if the Grantor of the IRA planned ahead and created and IRA Trust. A properly drafted IRA Trust could accumulate twice as much family wealth over 25 years compared to having taken the entire IRA distribution as soon as possible after the Grantor’s death.
1. The IRA had a balance of $750,000 at the date of the Grantor’s death;
2. Grantor died at 70, prior to having to take Required Minimum Distributions (“RMD”);
3. The designated beneficiary was qualified and 42 years old upon Grantor’s death;
4. Distributions from the IRA are taken on 12/31 of each year;
5. IRA and Accumulated RMD’s earn 8% pretax income;
6. Earnings taxed at 28%; a blend of ordinary and capital gain rates;
7. Distributions from the IRA are taxed at 39.6%; and
8. In Option 2, the distribution was taken from the IRA on 12/31 of the 5th year after death.
Not only would a properly drafted IRA Inheritance Trust or Trust provision allow for the stretch of the inherited IRA and accumulation of significantly higher sums, but such a stretch IRA Trust could provide the additional benefits of asset protection, divorce protection, protection for minors, protecting a “spendthrift” beneficiary from himself or herself, protection from losing certain government benefits, minimizing future estate taxes, and providing a legacy. In the example above, the $2,050,168 remaining IRA balance at the end of 25 years would be protected against the claims of creditors; whereas, the balances under Options 1 and 2 would be exposed to such claims.
What does it take to qualify and a valid IRA Stretch Trust? Under Internal Revenue Code §401(a)(9) regulations, a trust will qualify as a designated beneficiary trust if it meets these four (4) requirements1:
1. The trust is a valid trust under state law, or would be but for the fact that there is no corpus;
2. The trust irrevocable or will, by its terms, become irrevocable upon the death of the employee;
3. The beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the employee’s benefit are identifiable from the trust instrument within the meaning of Treasury Regulation 1.401(a)(9)-4, Q&A1;
4. The documentation described in Treasury Regulation 1.401(a(9)-4, Q&A 6 has been provided to the plan administrator (generally by October 31 of the year following the year of death).
Where multiple beneficiaries exist, it may be possible to divide the account into separate accounts payable to each beneficiary2. The regulations provide that separate shares must be established no later than December 31st of the year following the year of death for purposes of determining the applicable distribution period. The significance of separate shares is that (1) each separate share will allow the share beneficiary to calculate required minimum distributions based upon his or her own life expectancy3; and (2) where multiple beneficiaries exist, one of which is not a qualified beneficiary, separate shares will allow for the life expectancy distributions for the qualified segregated shares.
What does it take to properly draft an IRA Trust or Trust provision? The IRS, in Private Letter Ruling 2005370444 provides significant guidance on how to structure a trust and beneficiary designation form when naming a trust as beneficiary of a retirement account. However, there are many potential pitfalls and additional options available to Grantor’s of an IRA Trust. We strongly suggest you consult with a qualified attorney, like those at Cook Sadorf Law, and your certified public accountant to guide you through this difficult, but rewarding, procedure.
Written by Rick W. Sadorf, CPA, Esq.
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1.Treasury Regulation 1.401(a)(9)-3, Q&A 4(a)(2)
2.Treasury Regulation 1.401(a)(9)-3, Q&A 4(a)(1)
3.Treasury Regulation 1.401(a)(9)-4, Q&A 5(b)
4.Treasury Regulation 1.401(a)(9)-8, A-3
5.Private Letter Ruling 200537044
6.Note: Private Letter Rulings from the IRS are opinions of the IRS on the specific facts for which rulings are requested and are not binding precedence upon the IRS.