When you pull money out of an IRA-type account (such as a traditional IRA, 401(k), SEP-IRA, 403(b), Simple IRA, TSP, Alaska SBS or similar account), you have to pay income tax on the amount pulled out. When someone inherits that type of account, they likewise have to pay income tax. But how much they have to pay and when, depends very much on how the inheritance is handled.
For example, let us say I receive a letter one day from a bank, telling me that my rich uncle, who recently passed away, left me as the beneficiary of his 401(k) worth $200,000. The bank asks me to fill out their attached form, indicating what I want done with the account, and send it back to them. The form has a lot of confusing options, so I select what appears to be the simplest option, which is to cash it out and send me a check. Then when I get the check, I put it into my own account. However when tax time comes around, my accountant gives me the bad news. I must now pay income tax as if all of that money was ordinary income in that one year. Not only do I now have to pay the IRS $70,000 (assuming I was pushed into a 35% tax bracket as the result of the inheritance), but I may have lost various tax breaks that I would have otherwise been entitled to, because I am considered a high earner for that year.
What I should have done when I received the letter from the bank, is gone to my own preferred financial institution and established a beneficiary IRA. I could then have the bank pay the money directly into the new beneficiary IRA, and I would only have to draw out a small amount each year and pay tax on the amount drawn out. The rest of it would grow tax-free in the account. If I had a serious need, or a year in which I was in a lower-than-usual tax bracket, I could draw out more. To the extent I did not draw it out, that initial inheritance might have grown into a very nice nest egg by the time I reached retirement age.
What does this mean?
So what does this mean for a person who has a lot of money in an IRA-type account, in terms of their estate planning? For most people, it just means that they need to tell their heirs that if they ever inherit a retirement account, they should see a tax professional before signing anything. And then, those people can just designate their heirs as the death beneficiaries on the account. Unfortunately this does not work for some people, either because their heirs are minors, or severely disabled, or struggle with addictions, or perhaps are just too irresponsible to resist the temptation to start pulling all of the money out and spending it. For those people, an IRA Conduit Trust (sometimes called a “stretch IRA trust”) may be part of the planning. IRA Conduit Trusts can be used for all IRA-type accounts.
What is an IRA Conduit Trust?
An IRA Conduit Trust is a device which does for that beneficiary, what they would be able to do for themselves if they were able. The Conduit Trust becomes the death beneficiary, instead of the particular heir. When you die, whatever portion of the retirement account you designated, pays into the Conduit Trust. The trustee, which is somebody you named while you were alive, then manages the trust according to certain rules. The trustee has to pay out a certain minimum amount each year, based on the life expectancy of the beneficiary. They can pay out more, depending on what rules you set when you established the trust.
A few caveats: First, there are certain advantages which only a surviving spouse receives on inheriting this sort of retirement account, so if you are married, you will presumably want to make your spouse the primary beneficiary on the account, and then name the IRA Conduit Trust as the backup or “contingent” beneficiary. Second, if all of your beneficiaries are adults, who are capable and responsible with money, and do not struggle with substance abuse, gambling, or other expensive addiction issues, there is no need for an IRA Conduit Trust. And third, this type of trust is usually not worthwhile unless there is a fair bit of money which will be going to the beneficiary you are concerned about. While there is no hard-and-fast rule, typically if you are leaving less than $100,000 in IRA-type accounts to a problem beneficiary, it is not worth setting up a Conduit Trust.
Interested in an IRA Conduit Trust?
For clients in Alaska, attorney Kenneth Kirk can draft IRA Conduit Trusts, when appropriate as part of the estate planning process. During the free initial consultation, he will be able to tell you whether this is something which he can recommend in your situation. Please consider contacting us if you are interested.
“Still others were saying ‘We have had to borrow money to pay the king’s tax on our fields and vineyards'”
– Neh. 5:4.