Inheriting an Individual Retirement Account - Part IV- Stretch IRA Trusts

The last few months, I have been writing a series on inheriting an IRA. You can read more about IRA inheriting options (here), tax issues (here), and trouble spots (here). Given the number of questions I have received on IRAs; I thought another post on IRAs was warranted.

A Stretch IRA Trust is a trust set up to be the beneficiary of an IRA upon a person's death. The current tax structure provides that only the minimum required distribution ("RMD") be taken out of the trust each year, and that the rest may be left to grow as an untaxed sum. The RMD is based on the remaining life expectancies of the trust beneficiaries: the younger the beneficiaries, the less is required to be withdrawn, and the more the assets in the trust will "stretch," or grow over time. The assumption is that the value of the assets in the IRA will grow faster than what is required to be withdrawn. Generally, the stretch IRA Trust is best suited to provide for younger generations.

What are the advantages of a Stretch IRA Trust?

There are several important advantages of a Stretch IRA Trust. The first is that a Stretch IRA Trust prohibits beneficiaries from cashing in the IRA all at once, which people often do without realizing that the IRA is then considered ordinary income and is subject to high federal and state taxes. (Commentators estimate that up to 90-99% of the potential inherited distributions, i.e. those resulting from a properly stretched IRA, are not taken advantage of and thus are lost.) Using a Stretch IRA Trust preserves the maximum amount of assets possible, subjecting only the RMD to income taxation.

Other advantages of the Stretch IRA Trust are attributable to trusts generally. For example, by appointing a trustee to manage the trust funds, the settlor ensures control over assets left to minors, to those who have special needs, or to those who are incompetent to manage their finances. Moreover, placing these assets in a trust protects them from creditors and prevents them from becoming marital property of the beneficiary (and thus potentially subject to claims by a divorcing spouse). Finally, property in a trust can avoid probate, and the delays and fees associated with it.

Issues to be aware of with a Stretch IRA Trust

Like everything in life, there are several potential pitfalls to be avoided when creating a Stretch IRA Trust. The first thing to note is that only an individual (or several individuals) may be named as a designated beneficiary of the trust. This means that if an estate or a charitable organization is named as a beneficiary, even in part, the IRA will be treated as having no designated beneficiary and the default rules for distribution will "kick in."ⁱ The second thing to note is that in order to serve as a Stretch IRA Trust, the trust must be considered a "conduit" trust. This means that the language creating the trust must indicate that the RMD's are to be paid out annually to the trust beneficiaries. If there is no such language, the IRS will look to all potential beneficiaries and their life expectancies to calculate what distributions are to be made. This may frustrate the intent of the grantor by leading to larger payouts, more money subjected to taxes, and less money left to compound in the trust. For a list of other frequent mistakes made when trying to "stretch" an IRA, click (here.)

The final concern when creating a Stretch IRA Trust is that there are currently proposals in the Senate and in President Obama's 2014 budget proposal to eliminate the use of Stretch IRA's altogether. If passed, these changes would require an IRA to be paid out within five years of the owner's death where the beneficiary is someone other than the owner's spouse. While special provisions for disabled people and minors would remain in effect, this change would effectively nullify the tax benefits for all other younger beneficiaries.

I stated it last time but inheriting an IRA is a complex issue with many tax penalties and consequences if you are not paying attention. Taking with your financial advisor, CPA or attorney is advised if you are confused about what to do.

Basics of Estate Planning: Capacity for Estate Planning Documents

Many of the clients I work with receive a "package" of documents in their estate plan. Many times the package will include a will, a health care power of attorney, a living will, potentially a trust (revocable or irrevocable) and a durable power of attorney. Many clients, and some attorneys, assume that the capacity standards to execute any of these documents are interchangeable. In fact, there are different tests for capacity according to the document to be executed.

What is "capacity?" In layman's terms, capacity is defined as the capability, or fitness to do something; a legal right, power, or competency to perform some act. Having the correct capacity drives whether a person's execution of a legal document is valid.

At the lower end of the "capacity" spectrum is that necessary to execute a will, called "testamentary capacity." Statutes regarding testamentary capacity typically require that the testator be "of sound mind." A common test for testamentary capacity requires that at the time the testator executes his will, the testator is able to answer in the affirmative to the following questions:

1. Whether the testator understood the nature of the act the testator was performing,
2. Whether the testator knew the nature and extent of the testator's property,
3. Whether the testator knew the identity of those who were the "natural objects of the testator's bounty," and
4. Whether the testator understood the will's disposition of the testator's property.

In his law review article "Capacity for Lifetime and Estate Planning," Robert Whitman writes that challenges to a testator's capacity will likely come if the testator leaves his property to an unusual or controversial beneficiary. Moreover, even if a testator had capacity at the time he executed his will; the will could also be challenged on the grounds that it was the product of undue influence by another person (often the donee) over the testator.

The second and third documents, the health care power of attorney and living will, are often combined in an instrument known as an "advance medical directive." Virginia, Maryland and the District of Columbia all recognize the use of such a document, although the jurisdictions' statutory language with regard to capacity varies slightly.

The advance medical directive allows someone to appoint another person to make health care decisions on his behalf if he becomes incapacitated, which is the health care power of attorney portion of the document. You can read more about AMDs by click here.

In Virginia, "any adult capable of making an informed decision" can execute a written advance directive. In D.C., such a person must be a "competent adult" who is "of sound mind." In Maryland, "any competent individual" may appoint an agent to make decisions on the person's behalf and express his or her medical preferences in an advance directive. There is strong feeling by many in the healthcare and estate planning arena's that the standards for healthcare documents are frequently at or below the standard for testamentary capacity is a reflection on what lawmakers believe is an appropriate area for state intervention.

The fourth document is a trust. Depending on the type of trust, different standards for capacity may apply. For a revocable trust, only testamentary capacity is required. This is consistent with the frequent use of revocable trusts as will substitutes, and the donor's freedom to change or terminate a revocable trust at any time. On the other hand, settlors of irrevocable trusts may be held to the higher standard of contractual capacity. This type of capacity tests not just the party's competency, but his ability to understand the nature of the agreement that he is entering into and the effect and scope of that agreement. Because an irrevocable trust cannot be changed or terminated before the time specified in the trust, it is important to inquire not only whether the settlor is competent, but also to test his ability to comprehend the nature and consequences of his actions.

The final type of estate planning instrument is a durable power of attorney. In this document, a person, the "principal," authorizes someone else, the "agent," to act on the principal's behalf. Because of the fiduciary nature of this relationship, the broad powers often granted to the agent, and the ability of the agent to act for the principal during the principal's incapacity, contractual capacity is also required for execution of a durable power of attorney. You can read more about powers of attorney by clicking here.

Estate of the Month: Hizzoner is Paying Estate Taxes

Ed Koch, the three-time mayor of New York, died this past February at the age of 88, leaving behind an estate reportedly valued at $10 to $11 million. While Koch's net worth was relatively modest when he took office (reported by the New York Times at $106,890.38 as of 1978), he enjoyed considerable financial success after his mayoral career ended in 1989. A lawyer, author, speaker, and radio host, Koch amassed a small fortune by the time of his death, which he divided between friends, charity and family members in his will. However, financial commentators estimate that almost one fourth of Koch's estate will be paid in federal or state taxes instead of passing to his intended beneficiaries.

As a life-long bachelor, Koch made several specific bequests to certain named beneficiaries: $500,000 to his sister and her husband jointly, $100,000 to his longtime secretary, $50,000 to his sister-in-law, and $50,000 each to her two children. He also donated $100,000 to set up a charity in his name. His residuary estate (aptly named to denote that portion of the estate left over after gifts, fees and taxes) will be divided equally among his sister's three children, Koch's nephews. Luckily, just like James Gandolfini, Koch's estate was large enough to administer these specific bequests.

However, because of a lack of advance planning with respect to his assets, Koch's residuary estate will be significantly lessened by federal and state taxes. In 2013, the portion of an estate worth over $5.25 million is subject to a 40% federal tax rate. In addition, New York State has an exemption amount of $1 million, with the rest subject to up to 16% in state taxes. Commentators estimate the total amount of taxes payable by Koch's estate at between $2.55 and $3.3 million. Whatever the exact number, federal and state governments will collect a considerable portion of money, some of which could have passed directly to Koch's nephews.

Koch had various options to reduce the taxes that his estate owed upon his death. The first option would have been to take estate planning steps while he was alive. He could have used his annual gift tax exemption to gift away up to $14,000 per year as he reached the end of his life. (You can read more about gifting here.) This kind of gift does not count towards the $5.25 million federal estate tax exemption, which means that it would have reduced Koch's taxable estate.

In light of the value of Koch's estate, a more effective and tax efficient strategy would have been to create a trust (or several) to be managed on behalf of his beneficiaries. While the costs and administration of a trust may outweigh the benefits for people with smaller estates, those with larger estates are well-advised to consider creating one. Had Ed Koch placed his assets into a trust instead of dividing them up in his will, he would have exercised the same level of control over the disposition of his funds, which seemed to be his chief goal in leaving specific sums to certain beneficiaries. Moreover, his estate would have enjoyed several benefits that come with the use of a trust instead of solely a will.

First, by virtue of placing his assets in a trust, Koch would have shielded them from claims by creditors and other third parties, such as his nephews' spouses in the case of divorce ⁱⁱ. Second, Koch's estate would have been able to bypass the cost, delays and legal fees associated with the probate process. Thirdly, Koch would have been able to maintain his and his beneficiaries' privacy with respect to the details of his wishes. And finally, up to $5.25 million of the money placed in the trust would have been exempted from the generation-skipping transfer tax.

While Koch's wishes were carried out in the strictest sense, his will failed to provide for cost- and tax-saving procedures that would allow his beneficiaries to reap the fullest benefit of the assets that he left to them. The disposition of Koch's estate serves as a prime example of the ways that good estate planning can preserve as much of a person's assets as possible, while a lack of planning can leave such assets vulnerable to taxes, creditors and other fees.

ⁱThese rules are as follows: if the person who created the IRA died before age 70 ½, the IRA assets must be distributed within five years of his death; if not, the assets are to be distributed over the person's remaining life expectancy.

ⁱⁱ If Koch had created a revocable trust, it is only upon his passing that any true level of creditor protection would have occurred because his trust became irrevocable upon his death.