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The Five Smartest Ways to Use IRAs In Estate Planning

One – Streeeeeeeeetch it Out

The benefit of putting your retirement savings into a traditional IRA (as opposed to an ordinary savings or brokerage account) is that you can contribute your earnings pre-tax. Yes, you will have to pay income taxes on the money eventually. But the longer the money is invested in the account, the longer you put off paying the taxes. That means you can invest that money you would have paid taxes on, earning more money over time. And it means that when you do eventually have to pay the taxes, you might very well be in a lower tax bracket than when you’re at the height of your earning power. You can wait all the way until you turn 70½, when you have to start taking mandatory distributions. But even then, if you take the minimum required distributions, you can leave the rest of your money in there even longer, stretching out that tax benefit.

So when you’re thinking about dipping into your IRA to buy that Corvette, think again. If you take the money out before you have to, you give up the benefits of putting off those taxes as long as possible. And if you’re younger than 59½ you’ll also have to pay a 10% early withdrawal penalty on top of the income taxes.

The stretching concept also applies to someone who inherits your IRA after you die. If you leave your IRA to someone younger than you are, they’ll have a better chance to stretch out the tax deferral over time, maximizing the benefits of the IRA.

Two – Give it All to the Wife

When you fill out the beneficiary designation form provided by your IRA account administrator, you can name anyone to receive the funds in your IRA when you die. You can give your hard-earned pre-tax cash to your kids, your brother, your favorite elementary school teacher—anyone you want. But if you’re smart, you’ll probably give your IRA to your spouse.

When you die, your IRA will change to an “inherited IRA.” That means that whoever inherits the account will immediately have to start taking mandatory distributions that grow larger over the course of his or her life. And the payments get locked into that beneficiary’s life expectancy. That means that if you leave your IRA to your sister, and she dies and leaves your IRA to her kids, the IRA will still be making mandatory distributions over your sister’s life expectancy, even though it’s her younger kids who own it now. This is true for anyone who inherits your IRA, young or old.

Anyone, that is, except your spouse.

Your spouse can treat your IRA not as an “inherited IRA,” but as his or her own IRA. Your husband can roll it over and keep it until he turns 70½ just like you could. And when he leaves the IRA to your daughter, the IRA will make distributions according to your daughter’s life expectancy, not your husband’s. Making your spouse the beneficiary of your IRA is like getting a free extension on the tax benefits. And besides, you were going to leave most of your property to your spouse anyway, right?

Three – Give your Taxes to Charity

Many people want to give to charitable organizations when they die. You might have a favorite charity, educational institution, hospital, or church that you want to support. You can’t take it with you, so you may as well do some good with it, right? If you do plan to give to a qualified charity, the smartest thing to give them is your IRA. A traditional IRA (not a Roth IRA) is composed of pre-tax income. By holding the funds in your IRA you can put off paying taxes on any of it until you turn 70½, but you still have to pay income taxes on every dollar you pull out.

The great thing about charities, however, is that they are exempt from incomet taxes. Smart planners who want to give to a charity give from their IRAs, because the charities can take all the money and not pay a dime in taxes. For example, suppose you have an IRA worth $500,000 and other investments worth $500,000. Congratulations—you’re a millionaire. You could give your investments to your church and your IRA to your son. The church would get $500,000 but your son would get an account worth much less after he’s paid taxes on it, especially if he decides to withdraw it all at once, rather than stretching it out (see above). However, if you’re smart, you’ll give the investments to your son and the IRA to the church. The church still gets no less than $500,000 because the church pays no income taxes, and your son gets $500,000 in investments he can spend right away.

It’s very smart to give your IRA to a charity, but be careful. It only works if your charity qualifies as tax-exempt by the IRS. And you want to give the whole account directly to the charity, taxes and all, rather than making taxable distributions to yourself and then giving the money to the charity.

Four – Split it Up

If you want to leave your IRA to more than one person, or to a trust for the benefit of more than one person (more on that in a minute), then you should split up the account. If you don’t do it carefully, then an IRA left to John and his son John Jr. will use John’s life expectancy for both beneficiaries. The way the IRS regulates inherited IRAs, you have to take bigger distributions the closer you are to death (which according to the IRS is age 85). Since John is older, his life expectancy is shorter than Junior’s, so John’s mandatory distributions will be bigger. That means fewer funds stay in the IRA tax-deferred, and the tax benefit to John Junior is reduced.

However, if you intentionally split the IRA into two accounts at death, one for John and one for John Junior, the separate accounting rule allows them to each use their own life expectancy for required minimum distributions. So John Junior can take substantially smaller distributions than his father, leading to overall tax savings for the family. A smart planner makes sure the account gets split between multiple beneficiaries to maximize tax savings.

Five – Use a Trust

Sometimes it’s smartest to leave everything to your spouse. But a lot of the time, it makes more sense to use a special, qualifying trust. It’s no wonder every professional estate planner makes a ton of trusts for clients—trusts are usually the most versatile and cost-effective way to plan where and how your wealth will be distributed when you die. It’s no different when planning where to leave your IRA. Normally, it’s not a good idea to leave your IRA to a company, as opposed to a person. The two exceptions to this rule of thumb are charities (discussed above) and qualifying trusts. As long as your trust meets certain technical qualifications to qualify as a “conduit trust,” you can leave your IRA to your turst, the trust itself is ignored for tax purposes, and your IRA passes to whomever you designate in your trust. That way, your trust doesn’t pay income taxes. So why is it sometimes smarter to leave your IRA to a trust than to the people you want to receive it? Three reasons:

  1. Creditor protection. If your beneficiaries have debts, a trust can protect the IRA from their creditors. Even in bankruptcy, where IRAs are usually protected, inherited IRAs are not. A trust can keep the money safe.
  2. Family complications. If you leave your IRA to your spouse and your spouse gets remarried to Jacque the pool boy, there’s nothing to stop Jacque and his kids from getting your IRA. A trust can be designed to keep the funds in your family, even if your spouse’s situation changes.
  3. Simplicity. If you’re smart, you’re already setting up a trust to govern how your wealth is to be distributed, so why wouldn’t you want your IRA handled in the same way, as part of the same plan?

Whenever you are planning for your future and finances, it is important to have the help of competent professionals. Contact an attorney for personalized advice and documents to get the most out of your IRA.

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