Leaving an IRA to a Loved One? How to Avoid a Tax Bomb

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  • An IRA trust is a terrific way to protect your IRA from wasteful spending by beneficiaries if you die
  • Federal IRA tax laws require that an IRA trust be set up correctly to avoid costly mistakes
  • This article explains the in’s and out’s of setting up an IRA trust to reduce Federal and New Jersey income taxes

Income Tax Planning for Your IRA

I recently read an interesting article on IRA’s and the importance of tax planning with beneficiary designations including the creation of IRA trust for protecting wealth from wasteful spending.  If this article speaks to you, call me and let’s discuss.

Here Are Excerpts from the Article Which Explains a Trust for an IRA

You wouldn’t leave your toddler with a pile of cash, right? A little known, but effective estate-planning technique may allow you to safely pass your IRA on to future generations — if you do it right.

When it comes to naming a beneficiary to a retirement account, the first person to come to mind is (likely) your spouse. Your kids, if you have them, might be a close second.

However, your children or grandchildren won’t always be in an ideal position to receive a windfall, particularly if they are minors, disabled or spendthrifts. That’s when a trust might make sense. “The real reason for having a trust as an IRA beneficiary is because there’s some element of control. It’s easy to mess up this, however.

In the first place, not all IRA custodians permit you to list a trust on your beneficiary form.

Second, the tax code has a specific list of conditions for trusts that act as beneficiaries to retirement accounts. Failure to closely follow the IRS rules could result in an accelerated distribution of your IRA and a raft of taxes.

Here’s What You Should Know about Setting Up an IRA Trust

In order for a trust to be viable as a designated beneficiary, it must meet a four-part test.

  1. It must be valid under state law.
  2. It must be an irrevocable trust — a trust that generally can’t be changed once it’s established — or one that will become irrevocable at your death.
  3. The beneficiaries must be identifiable from the trust document.
  4. The IRA custodian or retirement plan administrator must have received a copy of the trust by Oct. 31 of the year following the year of the IRA owner’s death.

There is an unofficial fifth rule. All of the trust beneficiaries must be actual people — not charities and not your estate. That’s because if your beneficiaries aren’t people, then your IRA may not have a designated beneficiary at all.

If your trust fails the test, it’s subject to the rules that kick in when you have no designated beneficiary for your IRA. That means your retirement account will be depleted earlier than you would have intended, your IRA must be distributed within five years after you’ve died unless you die after you started your RMDs, then your distributions will continue to pay out over what would have been your remaining (and presumably shorter) life expectancy.

Multiple Beneficiaries and the Importance of Beneficiary Designation to Your IRA Trust

Perhaps you have several children, and you’d like to pass your IRA proceeds through a trust for their benefit. The best way to proceed is to consider creating a trust for each child. Separate trusts allow each beneficiary to have distribution based on his or her own life — and they also reduce conflicts among heirs. Be sure that your trust documents clearly state the names of the beneficiaries, so that it meets the IRS four-part test. “It’s better to name the kids individually than to do something like ‘for the benefit of my three children. Avoid these mistakes Review your beneficiary forms: Why go through the work of setting up a trust if you’re going to omit the key step of naming it as the IRA beneficiary? Revisit your beneficiary designations and make sure they reflect your wishes.

If you have separate trusts for your beneficiaries, name them on the form. Don’t be vague about your trust details:   Specificity is everything. Be sure that your trust beneficiaries are identifiable by name, and make sure that they are people — not charities and not your estate.

To discuss your NJ Estate Planning matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com.  Please ask us about our video conferencing consultations if you are unable to come to our office.

By Fredrick P. Niemann, Esq., of Hanlon Niemann & Wright, a Freehold Township, Monmouth County NJ Estate Planning Attorney

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