For many readers, retirement assets constitute a significant portion, if not the majority, of their net worth. Except for Roth IRAs and Roth 401k accounts, all retirement assets come with substantial tax liability. (For simplicity, I’ll refer to all tax-deferred retirement assets as IRAs.)
To begin with, IRAs don’t belong in your probate estate, where they’ll be exposed to probate delays and costs, robust income taxes and your creditors, and may end up in the hands of people you didn’t intend. Be sure you’ve named the beneficiaries you want in the form provided by the custodian.
Because withdrawing a large amount of retirement assets in any given year will generate income tax liabilities at an overall rate that could easily exceed 40 percent, planners usually advise people to preserve IRA tax deferral as long as possible. This is known as “stretching out” an IRA.
Unless there’s a “designated beneficiary,” all retirement assets must be withdrawn soon after death, the worst possible result financially. “Designated beneficiary” is a narrow technical term that includes only those who, like individuals, have a life expectancy. Estates are not designated beneficiaries, nor are charities. Trusts cannot be designated beneficiaries unless they qualify as a “Designated Beneficiary Trust” (more on this option later).
For designated beneficiaries, the required minimum distributions (RMD) are determined by two age-dependent tables, one for surviving spouses who take a deceased spouse’s IRA as their own (often called a “Spousal Rollover”), and one for all other individuals, including spouses who don’t take the deceased spouse’s IRA as their own. You can find the tables online in IRS Publication 590, Appendix C.
Spousal Rollover IRAs (Table III). RMD must begin when the surviving spouse reaches age 70.5, initially at about 3.65 percent of the balance the preceding December 31. Each following year, the IRA is revalued and the required distribution percentage increases. At the following ages, the amount of RMD equals the following approximate percentages: 72 = 4 percent; 78 = 5 percent; 83 = 6 percent; 87 = 7 percent; and so forth.
If the surviving spouse can maintain a 7 percent average investment return, the Spousal Rollover balance should continue to grow until he or she reaches age 87, then begin to decline as the withdrawal percentage continues to increase.
Other Designated Beneficiary IRAs (Table I). RMD must begin the year following death and is determined by multiplying the value on December 31 of the year of death by a fraction, the numerator of which is 1 and the denominator of which, found in Table I, is based on the beneficiary’s age at the original IRA holder’s death. Each year thereafter, the denominator is reduced by one and the fraction is applied to the value of the IRA on the prior December 31.
For example, if the beneficiary is age 70 when the IRA owner dies, her original denominator would be 17. In the year after death, she must withdraw 1/17 (about 5.9 percent) of the prior December 31 value. The following year, she must withdraw 1/16 (6.25 percent) and so forth, until the entire IRA is depleted when she reaches age 87, the same age at which the Spousal Rollover would just be reaching its maximum value if investment returns average 7 percent.
Suppose instead that the beneficiary is 32 years old when the IRA owner dies. His denominator will be 51.4, and he must withdraw 1 divided by 51.4 of the balance in the year following death. The next year, he must withdraw 1 divided by 50.4 of the remaining balance, and so on. Assuming the beneficiary takes only the minimum distributions, his inherited IRA will last until he reaches age 83. And if he invests wisely and achieves returns averaging 7 percent annually, his inherited IRA will continue to grow until he reaches age 69.
Designated Beneficiary Trust. Designated Beneficiary Trusts can be useful, but have drawbacks. In addition to the administrative costs of any irrevocable trust, their withdrawal provisions are less favorable than those of Spousal Rollovers and direct beneficiary IRAs. And, the IRA holder must make a choice between a “Conduit Trust” and a “Non-Conduit Trust.”
In a Conduit Trust, the “income” is defined as the entire RMD, which flows through the trust to the beneficiary. The age of a Designated Beneficiary Trust for RMD purposes is the age of the oldest designated beneficiary. Thus, a Conduit Trust providing income to the 70-year-old spouse for life, with the remainder to the 32-year-old son, would follow Table I for age 70. If the surviving spouse makes it to age 87, there will be no remainder for the son. At best, a Conduit Trust may keep a spendthrift spouse from consuming the IRA too quickly, but it won’t assure there’s something left for the next generation.
The Non-Conduit Trust is structured as a “Unitrust,” whose assets are revalued once a year and the “income” is determined by multiplying a constant percentage by the prior year’s value (much like a Spousal Rollover IRA, except the percentage doesn’t increase). Also, the RMD doesn’t all flow through to the surviving spouse. Instead, the spouse receives an amount determined by applying the Unitrust percentage to the total trust assets, including the value of the IRA.
The IRS requires that, to avoid estate taxes at the IRA owner’s death, the Unitrust percentage must be at least 3 percent and not more than 5 percent. The larger the Unitrust percentage, the greater the portion of the IRA that will be distributed to the surviving spouse and the smaller to the remainder beneficiary(ies).
Although the income stream to the surviving spouse will be smaller than that provided by a Spousal Rollover, the Non-Conduit Trust will ensure that the pool of funds is available for her lifetime and there’ll be something left for the next generation. A negative: Income retained by the trust is taxed more heavily than that paid out to the beneficiary.
