This subject led me to write a book in the late 90s called Avoiding Tax Traps In Your IRA which was endorsed by Kiplinger’s Retirement Reports. In my research for the book, I discovered a minefield of tax traps which caused individuals to lose substantial money to taxes and penalties.
I will use this blog to emphasize some of the problems I encounter in a typical estate. If you have any type of retirement plan, estate planning is a must.
Hypothetical: Husband and wife visit my office for an estate plan update. Each has an IRA and the husband owns a 401K plan. They own a home, investment account and cash accounts.
The home is valued at $500,000, the investment and cash accounts at $300,000. The husband’s IRA is valued at $400,000, his 401K is $600,000 and the wife’s IRA is valued at $500,000.
The home, investment and cash accounts are in the name of the Family Trust. The Retirement funds cannot be owned by the Trust. Retirement plans can only be owned and in the name of individuals. However, the Trust may be named as the beneficiary of the retirement plans. In this case, the husband and wife have named each other as the primary beneficiary of their retirement plans and the Family Trust as the contingent beneficiary.
So, the Family Trust assets of the husband and wife are valued at $800,000 and the retirement funds are valued at $1.5 Million, almost twice the value of the Trust assets.
My first question in this regard would be: “Do you have a copy of your beneficiary designation form for you retirement plans?” Answer, “I’m not sure, but I’m confident that the financial institution has one.” “OK, but what if they don’t or can’t locate it at your death,” I ask. Why would you place $1.5 Million in potential jeopardy by not retaining a copy of your beneficiary designations. It is vitally important so that you know for sure who is the designated beneficiary on your retirement plan. Obtain a copy of your present designation from the retirement plan custodial institution and keep it with your Family Trust and other important documents.
My next inquiry with the husband and wife is whether they have a Financial Durable Power of Attorney (DPA)? The husband and wife say they are not sure and search the brief case of documents they brought to the consultation. Finally they locate the DPA and ask of its importance. The reason the DPA is important with owners of retirement plans is that it is the only legal document that provides control over such plans. THIS IS IMPORTANT! If you are unable to make decisions, because of incapacity, regarding your retirement plan, who can do that for you? The husband and wife respond, “The Trustee of the our Family Trust.” How can the Trustee make decisions on the retirement plan when the Trust can’t own the IRA? The Trustee can’t, as the Trustee can only control Trust Assets. Ok, the husband and wife say, “can’t my spouse make decisions for me if I’m incapacitated?” Wrong again. The spouse is not the owner of your retirement plan, he/she is the beneficiary. Beneficiary’s can’t make decisions on your retirement plan while you are living. So, who then? Your agent designated in your DPA on the condition that authority is specifically provided in that document. When I review DPAs, I always look for detailed authority over retirement plans. As I look at the DPA of the husband and wife I cannot find any reference to retirement plan authority. How can this be? A husband and wife with $1.5 Million in retirement funds and the drafter of the DPA didn’t even include retirement plan authority. If one of the spouses lost capacity, the other spouse would have to resort to a Court order (usually through a Conservatorship) to make any elections or options concerning the incapacitated spouse’s retirement fund.
In this particular case, I would recommend replacing the DPA so as to include retirement plan authority. If this DPA was this lacking I would not use it as an amendable document but replace it entirely with my version of the Uniform Durable Power of Attorney (UDPA) under the California Probate Code.
I want to conclude this article with a major tax trap of which you must be aware. It’s called an Inherited IRA. An Inherited IRA is exactly that, one inherited, usually from a parent. Unlike a spousal beneficiary, Inherited IRAs cannot be rolled over into the name of the beneficiary without dire tax ramifications.
Example: Husband dies and owns two IRAs at death. He has designated his wife as the beneficiary of one and his daughter as the beneficiary of the other. His wife may rollover the first IRA as a spousal rollover and become the owner of that particular IRA. However, his daughter cannot rollover the second IRA as it is an Inherited IRA. She will merely add her name and social security number as the beneficiary for income tax reporting purposes. Her father’s name must remain on the IRA. If she were to remove her father’s name and replace it with her name, the IRA institution must report it as a distribution of the entire IRA fund in the year of the action taken by the beneficiary.
Anytime an IRA is involved in the estate, we clarify these rules in the Administration of the Estate on the death of the IRA owner. I highly recommend that you obtain professional advice from a competent tax professional before taking any action in this regard.
TAX ADVICE DISCLOSURE: To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.