Question: Right now, I have planned to leave my Individual Retirement Account to my son. I assume that he will outlive me, since he’s in his late 50s while I’m pushing 85. But I am wondering whether this is the best choice.
He and his wife have been doing pretty well, and they have a number of retirement accounts of their own. I have been wondering whether I should give the account to him or give it directly to my grandchildren. My other thought would be to just name the trust that my wife and I created before her death and have it get distributed that way — first to my son and then what is left to his children. What would be best?
Answer: From what you say here, you will likely want to designate your grandchildren as individual beneficiaries in the plan documents, not designate your living trust as a beneficiary. It pays to be young.
Although it is possible and sometimes even desirable to name your trust as a beneficiary of the IRA, it can raise problems. Under some circumstances, naming the trust as a beneficiary can result in the deferred income in the IRA being taxed in a short period of time. That could mean a significant increase in the amount of taxes paid and a loss to this type of investment.
There are, however, some situations where it is advisable to name a trust as a beneficiary of an IRA. But this should only be done after careful planning and professional advice, as there are some tricky aspects to trust drafting in these situations.
Designating individuals is usually preferred, as it means that the beneficiaries can “stretch” the distributions out over their lifetime. To understand the benefit of the “stretch,” it is necessary to understand the rules of the “required minimum distribution” or “RMD.” When a person inherits an IRA, the recipient — regardless of age — must take a RMD each year. This is in contrast to a traditional or SEP IRA, where the owner is only required to take RMDs in the year after turning the age of 70½ years.
For inherited IRAs, there is a formula for determining the RMD. The annual RMD is the account value divided by a “factor” that correlates to the age of the beneficiary. The factor gets smaller as the age of the beneficiary increases. The younger a beneficiary is, the higher the “factor,” resulting in a lower annual RMD. Since IRA distributions are taxed as ordinary income, the less that is distributed each year, the less likely the recipient of distributions will be pushed into a higher tax bracket.
For example, assume that you pass away with a $500,000 IRA, leaving it to your son who is 59 at the time of your death. According to law, his RMD factor would be 25.2, resulting in a RMD of $19,841. If, however, you leave the account to your 28-year-old granddaughter, the factor would be 54.3, resulting in a RMD of $9,208. That’s $10,000 of funds in the first year alone that would not be subject to federal income tax and instead allowed to grow.
Note that the relative amount of the RMD will increase over the beneficiary’s lifetime because the factor decreases each year. Perhaps the old adage about youth being wasted on the young is true, but it is clear that younger beneficiaries get more of the tax-deferred benefit of an inherited IRA.
You don’t mention the size of the IRA and the value of your other assets in the estate, so there may be other factors to consider here. In particular, federal law has some rules limiting non-taxable transfers to grandchildren in an effort to skip over wealthy children. You don’t want to run afoul of these regulations, so you should seek the advice of a lawyer and also your accountant before making any specific decisions.
Last but not least, in making the decision not to leave your IRA to your son, it is important to consider his needs. While he may be doing well now, will he have enough money for a comfortable retirement? If you are confident that he has the resources to support a comfortable retirement, then leaving the IRA to your grandchildren would be a wonderful gift to them.
Preston Morgan is a partner at Kopper, Morgan & Dietrich, a Davis law firm providing family law, estate planning and trust litigation representation. His column is published every other week in the Davis Enterprise. To pose a question to Preston Morgan, contact him at https://kopperlaw.com.
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