Say you meet up with a married couple in their mid 60s with three adult children and a net worth of $3 million — $1.5 million in his IRA, $500,000 in their home and $1 million in nonretirement mutual funds. Since the husband is likely to die first, a clever estate-planning attorney has told them to split their assets up as follows:
When the husband dies his IRA goes first to his wife, who can then “disclaim” the IRA. It then goes to a credit shelter trust with the kids as beneficiaries, yet his wife would still be able to get money out of the trust for her maintenance (no Botox jokes, please), education, support or health reasons.
She would get the house and the non-IRA money. When she dies, the kids get whatever is left over from this asset pool.
It seems a perfect arrangement. As long as the IRA and her half of the assets are each under the exempt amount ($1.5 million in 2005, going to $3.5 million by 2009) at the time of their respective passings, little or no “death tax” would ever be paid.
The attorney's actions have likely saved the family six figures in potential estate taxes — not bad for a few thousand dollars in legal bills. But what you can point out to your soon-to-be-shocked couple is that the lawyer may have cost their family millions in income taxes.
When It Works … and When It Doesn't
The lawyer is not to be blamed — he or she is trained to help clients save on estate taxes, not income taxes. Plus, the family may have motivations beyond the tax liability of the inheritors. For instance, language can be added to the trust document that might prevent squandering children, outlaw in-laws or an unfortunate lawsuit verdict from cleaning out the account faster than the parents originally intended.
If the mother or her children are likely to need the money in the trust relatively soon after the father's death, compliment the family on their astute maneuvering, then move on to the next step in the planning process. But if asset protection is not a priority, and the surviving family members are otherwise financially secure, the current arrangement could be disastrous to their dynastic inclinations.
The problem arises because the wife/mother still has an interest in the trust. So each year's required minimum distribution from the IRA is based on her life expectancy. If the mother had no ability to tap the account, then the distributions would be based on the longer life expectancy of the oldest child.
How much difference could it make to remove the mother as a beneficiary of the IRA? Let's say that the account earns 8 percent per year and the father dies at 80: After the required minimum distributions are taken, the IRA balance is about $3.2 million. If the mother retains an interest in the beneficiary trust, the total of the minimum distributions will equal about $5 million over the next 10 years, when it will then be depleted. If the family members are in a net income tax bracket of 35 percent, they will pay about $1.75 million in income taxes on the distributions after the father dies.
But say the children are the only beneficiaries of the IRA or the trust inheriting the IRA and the oldest child is 50 when the father dies at age 80: In the 10 years after the father's death, the required minimum distributions total about $1.4 million, with taxes paid of around $500,000. The balance remaining in the tax-sheltered retirement account is still $5 million. And under this scenario, the IRA will last 23 years longer than it would under the “mother included” hypothetical and will kick out distributions totaling over $17 million.
Education vs. Expiration
Confused yet? Good. Lesser advisors gave up after the first paragraph of this column, content with the notion that giving out a sleeve of golf balls is a preferable way to get and keep clients with million-dollar retirement plan balances.
The truth is that your success in this industry over the decades could be determined by your skill in handling large retirement distribution and estate-planning complexities. Becoming a financial expert in the byzantine regulations and loopholes will elevate your status in the high-net-worth investor community, and your earnings should rise accordingly.
After all, the dictionary is the only place where “income” occurs before “intelligence.” Two of the industry's leading sources of information on IRAs, distributions and beneficiaries are CPA Ed Slott (irahelp.com), and attorney Natalie Choate (ataxplan.com). Spend a few dollars learning what they know — the investment could come back to you thousand-fold.
And you really are only required to know the basics of combining estate-and retirement-planning techniques. A qualified estate attorney will do the heavy lifting. You can start your search for one by going to martindale.com, then clicking on the “trusts and estates” section of the site's screening tool.
Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com
Three for the Road
Key strategies for smoothing the transition of money from one generation to another.
Rather have a Roth? Clients with enormous IRAs can alleviate both income and estate tax concerns by converting some or all of the retirement account to a Roth IRA. There is no required minimum distribution for Roth IRA accounts while the owners are alive, and the money that pays the conversion tax will, of course, be removed from their taxable estate.
“M” is for the money she's losing. Removing the mother's interest from the IRA beneficiary trust could cause her some distress. To make up the difference, consider making her the beneficiary of an insurance policy on her husband's life.
Free money? No thank you! The more opportunities your clients give their heirs to disclaim their inheritances to other more appropriate beneficiaries, the more tax-avoiding flexibility they will have down the road.
What a Difference Mom Makes
A father dies at age 80, leaving an IRA worth about $3.2 million. Here's the difference between including his wife of the same age as a beneficiary, versus leaving the IRA directly to his children — the oldest of whom is 50 when the father dies.*
| With Mom | Without Mom | |
|---|---|---|
| 1. Required distributions over the 10 years after father's death at 80 | $5,000,000 | $1,400,000 |
| 2. Taxes on distributions over the next 10 years | $1,750,000 | $500,000 |
| 3. Balance in IRA 10 years after father's death | 0 | $5,000,000 |
| * Eight percent hypothetical annual return projected, taxes on distributions calculated at a rate of 35 percent. | ||