Many taxpayers have IRA’s, 401-K’s and other deferred-compensation accounts as part of their financial planning strategy. Such accounts enable taxpayers to defer the payment of income tax until they retire – when they supposedly will have less income and withdrawals will hopefully be taxed at a lower tax rate.
Such accounts typically offer the taxpayer the opportunity to designate a beneficiary, to whom the account will be distributed in case the taxpayer dies before receiving the entire account balance.
How does the existence of tax-deferred accounts coordinate with estate planning? When we form a Revocable Living Trust, we don’t “put the IRA in the Trust,” because the IRA already has a trustee. If we were to re-title ownership of the IRA in the name of the Trustee of the Trust, that would constitute receipt of the asset by the Taxpayer/Trustor, causing the instant implementation of the (otherwise deferred) income tax.
So how may the Taxpayer pass ownership of the tax-deferred account without probate?
Usually, the married Taxpayer will name his/her spouse as beneficiary of the IRA. Under current IRS rules, if the taxpayer dies, the spouse may then “roll over” the account – further deferring the income tax. If the Taxpayer has a trust (which becomes irrevocable at the Taxpayer/Trustor’s death) he/she may designate the Trust as the alternate, or contingent, beneficiary, in case the spouse predeceases the taxpayer, or as the primary beneficiary if there is no spouse. If the Taxpayer dies, and the Trust receives distribution of the IRA, the Trust must pay the deferred tax, but the net proceeds are then available to provide for such beneficiaries as minors or others to whom a present distribution is not contemplated.
Sometimes, the taxpayer wants the IRA to benefit someone outside of the Trust. If the beneficiary is a child of the taxpayer, he/she may pay out the tax over five years. If the beneficiary is anyone other than the taxpayer’s spouse or child, such beneficiary will have to pay the tax without further rollover or postponement.
By careful consideration of the needs of beneficiaries and their different potential tax treatments, the Taxpayer/Trustor can maximize the benefits of such tax-deferred accounts, both for financial planning and estate planning purposes.
Jerry Kessler practices law in Santa Clarita. He may be reached at 661-255-1001.