Lynn Brenner's Family Finance

The Most Common Estate Planning Mistakes Involve IRAs

Q: I'm finally getting around to writing a will, something I realize I should have done years ago. My biggest assets other than my house are my IRAs. I've never done any estate planning. Are there any common mistakes to avoid? --EM via email

 

A: Indeed there are, and none are more common than those involving IRAs!

Your first step should be locating a good estate lawyer. (I've explained how to do that in this  earlier post.) Contrary to popular assumption, not every lawyer is qualified to write a will, says Stephen J. Silverberg, immediate past president of the National Academy of Elder Law Attorneys.  "Estate planning is a legal specialty, just as cardiology is a medical specialty."

Step two: Take copies of your IRA beneficiary designation forms with you. Ask the lawyer to read them, make sure you've filled them out correctly, and explain the fine print. Those forms are the legal documents that determine who gets your IRAs  -- not your will!

If you don't have copies of your beneficiary designation forms -- and most people don't -- now is the time to get them, says Silverberg.

Most people assume their bank or broker has these forms on file and can easily retrieve them. Don't be so confident that your financial provider is more organized than you are! Misplaced forms are a longstanding problem, says Ed Slott, a tax accountant and IRA expert: "Banks and brokers go out of business, financial advisers are laid off, and client forms are lost." Silverberg recalls one case in which a brokerage finally located missing IRA paperwork in a cardboard box under the office coffee machine.

What if the forms are missing? No problem -- as long as you're alive. You can just fill out new ones.

The reason so few people ask the lawyer who draws their will to read their beneficiary designation forms is that  they mistakenly assume that their will supercedes whatever the forms say. Lawyers know better. Nevertheless, "I'd say 90 percent of lawyers who prepare a will don't ask to see the client's IRA beneficiary form," says Silverberg.

The wording of beneficiary designation forms varies from one financial company to another, but its main purpose is to protect the bank or brokerage that serves as IRA custodian -- not you or your family.

Your lawyer should make sure that the fine print won't cost your kids money.

For example, if your heirs decide to move the IRA to a different custodian, they must do it in a direct, trustee-to-trustee transfer to avoid triggering taxes. Some banks don't allow beneficiaries to do this type of transfer, says Slott.  "They'll only give your children a check for the whole IRA, which makes it immediately taxable."

If your custodian doesn't let  IRA beneficiaries do a tax-free transfer to its competitors, you can -- and should -- move your money to one that will. As the IRA owner, you can do a tax-free transfer anytime you want.

Your lawyer should also make sure you filled out the beneficiary form clearly and correctly.

Slott remembers a situation in which six siblings inherited their mother's $600,000 IRA. Her beneficiary form listed their names, but it didn't specify how large a share of the account each child was to receive. "The bank decided the first named child was the primary beneficiary, and the others just contingent beneficiaries," says Slott. "It paid the entire IRA to the oldest child. To divide it with her siblings, she had to withdraw the money, paying more than $240,000 in taxes that could have been avoided if the mother had just put two words on the form: 'equal shares.'"

Your lawyer should also make sure these forms allow your heirs to name successor IRA beneficiaries. That way, if your grandchildren prematurely inherit the accounts, they can continue taking distributions from your IRA based on their parent's life expectancy. The law permits that -- but some custodians' rules do not.

Again, if you're not satisfied with the bank’s rules, move your IRA to another provider.

(Part of this post is based on my article 'Who'll Get Your IRA?' published last year in AARP The Magazine.)

 Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

 

Is My Inherited IRA Subject to EstateTax?

Q: My mom passed away in November 2010. She was a New York resident and left an IRA with two beneficiaries, myself and my sister. Is that IRA considered an asset for the purposes of New York State estate taxes? The bank has already completed transfer of the IRA distributions. I’ve rolled my portion to a new IRA to avoid tax liability, and my sister took her portion in cash. I live in another state and I’ve been advised that this IRA wouldn’t be considered a taxable asset if mom had lived here. But I need to know if it is in New York. –DM

 

A: No matter what state you live in, your estate is the value of everything you own at the time of your death -- and that means everything, from your tax-deferred retirement accounts to the loose change on your bedside table. But not all states have an estate tax; and even the ones that do have an estate tax don't tax every estate.

New York taxes estates whose value is greater than $1 million. Let's say your mother’s total estate – including her IRA – was worth $1.2 million. In that case,  a New York estate tax is due on the $200,000 excess. If her estate was worth less than $1 million, there's no New York estate tax. (In case you're wondering, in 2010 there was no federal estate tax. In 2011 and 2012, federal estate tax appies only to estates worth more than $5 million.)

Don’t confuse estate taxes with income taxes. These are two entirely different sets of taxes, with different rules, tax rates, and exemptions!

Regardless of whether your mother’s estate was taxable, you and your sister will owe income taxes on the money you take out of her IRA. If the IRA is worth $200,000, for example, and you take a $10,000 distribution, that $10,000 is added to your taxable income for the year.

Your sister took her portion in cash. If she took it in 2011, she’ll owe income taxes on the amount of her cash distribution in April 2012.

You say you transferred your share into a new IRA to avoid tax liability. As I explained in an earlier post, that new IRA must still be titled in your mother’s name to preserve its tax-deferred status. Your name can be on the account too, but as its beneficiary, not its owner.

If you’ve done this transfer correctly, you’ll only owe income taxes on your annual IRA distributions. (You must take a minimum yearly distribution from the IRA based on your life expectancy.)  But the balance of the account will continue to grow tax-deferred.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Retirees Must Spend Principal, not Just Investment Income

Q: You recently wrote that retirees should withdraw only 4% a year of their nest egg. I've read this before. But no one addresses the fact that if the assets produce 4% per year -- and all records show that the stock market has returned more than that over the last umpteen years -- the principal would barely be touched.

I'm retired, and most of my assets are in stock and bond mutual funds. My income consists of Social Security and dividends and interest from my investments. If I need more income, I take some principal. Hopefully, my investments' growth will maintain enough of my principal to last for the next 30 years. My point is that retirees seem to have problems with taking a little principal for a little enjoyment. No one ever mentions that there's nothing wrong with taking some principal if you need it for something special. --JC via email

 

A: You're right that too few retirees understand that it's okay to spend principal in retirement. In fact, for all but the richest retirees, it's more than okay. It's both sensible and necessary.

The 4% formula I described in my earlier post assumes that you’ll be withdrawing investment principal as well as earnings. In fact, it’s a plan that essentially turns your portfolio into a 4% inflation-adjusted immediate annuity.  An immediate annuity pays you income for life – and each annuity payment includes some of your principal along with earnings.

Many people point out, as you have, that stocks historically have returned more than 4% a year – and they conclude that a 4% withdrawal rate must leave your principal untouched.

Unfortunately, this isn’t true, for two reasons:

The first is that the 4% withdrawal plan includes an annual inflation adjustment. If you retire with a $1 million nest egg, for example, your first annual withdrawal is $40,000 – 4% of your balance. If the annual inflation rate is 3%, the following year you withdraw $41,200 -- $40,000 plus 3% ($1,200) for inflation. If the inflation rate is 2% the year after that, the next year you withdraw $42,024 -- $41,200 plus 2% ($824) for inflation. And so on.

In other words, a more accurate name for this strategy would be ‘the 4% plus-annual-inflation-rate withdrawal plan.’

The second reason is that there's a huge difference between the market's average return over umpteen years and its return in any single year.

You're right about the long-term numbers. From 1980 through 2010, for example, the Standard & Poor’s 500 Index delivered a handsome 11.44% average annualized return. During the same period, the Barclay’s Aggregate Bond Index (which used to be called the Lehman Brothers Aggregate Bond Index) had an 8.71% average annualized return.

But that doesn't mean that every year during that three decade period stocks grew 11.44% and bonds grew 8.71%!  Or even that they delivered those returns in typical year. An average is just that -- an average. The good years were much better; in 1997, for example, stocks gained 33%.  And the bad years were much, much worse. In 2008, stocks lost 37%. Bond swings were less violent, but bond returns fluctuated dramatically too. In 1991, bonds gained 16%. In 1994, they lost almost 3%.

It's natural to focus on long-term average rates of return when you’re saving for retirement: If you won’t spend your money for 30 years, the 30-year average annual return is more relevant than this year’s return. It's a different story when you’re living on your savings! Sure, in the long run, stocks have outpaced inflation. But you have to eat in the short run, too -- and in the short run, the stock market often has lower-than-average and/or negative returns.

The result: when you withdraw 4% a year plus inflation from your portfolio every year for two or three decades, by definition you’re withdrawing principal.

I should add that the 4% formula assumes that you’re invested in a mix of stocks and bonds. You need the stocks so your principal has a shot at outpacing inflation. And you need the bonds to cushion your losses, calm your nerves, and help you avoid selling stocks at a loss in bad years.

Most retirees would love to live on investment income, preserving their principal for emergencies and/or their children’s inheritance. Unfortunately, this plan only works if you're fabulously wealthy or have such a short life expectancy that you don't need to worry about inflation.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Can A Widow Collect Social Security While She Works?

 Q: My cousin is 63 years old. Her late husband was was collecting Social Security when he died at age 65 in January 2011. She has contacted the Social Security Administration about collecting on his Social Security until she turns 66, when she will be entitled to collect her own full benefit based on her work record.

They told her she couldn't collect on his Social Security because she is still employed.

Is this correct?

I thought that she was entitled to collect a benefit on her deceased spouse's Social Security. --JO via email

 

A: You're right. Your cousin was either misinformed or she misunderstood what she was told. Having a job doesn't disqualify her for a survivor's benefit; but depending on her annual salary, she may be unable to collect it until she turns 66.

Before discussing her best course of action, let's recap the rules:

A widow or a widower is entitled to a survivor's benefit based on her/his deceased spouse's work record. (Divorced people who were married for ten years or more and haven't remarried are also entitled to this survivor's benefit when their former spouses die.)

You forfeit this benefit if you remarry before turning 60. If you remarry after 60, you can keep it.

Your maximum survivor's benefit is 100% of what your deceased spouse would receive if he or she were still alive. In other words, if a man was getting a reduced benefit when he died because he filed for Social Security before his full retirement age,  that reduced amount is the maximum his widow can get. And he was receiving a bigger benefit because he postponed taking Social Security until after his full retirement age, that's what she'll get.

The earliest you can start collecting a widow or widower's benefit is age 60. But to get your maximum survivor's benefit, you must delay collecting until  your own full retirement age, which in your cousin's case is 66 years old. At age 62, she can only receive 81% of her deceased husband's benefit.

Clear so far?

Then let's move to your second assumption, which is that your cousin can collect her widow's benefit at 62, and then switch to her own benefit at her full retirement age.

You're right about that, too! It's a wrinkle in the rules that even some Social Security staffers don't know about. 

If you apply for Social Security before reaching your full retirement age while your spouse is alive,  your application automatically applies to both your own benefit and your spousal benefit -- and you get the larger of the two. You can't take one and postpone the other.

But a widow or widower can do just that:  At 62, your cousin can collect 81% of her late husband's benefit, and postpone taking her own benefit so that it keeps growing. Or she can decide to take her own reduced benefit now -- at 62, she'll get 75% of what she'd get at age 66 -- and switch to a 100% survivor's benefit when she turns 66.

The best choice obviously depends on the relative dollar amounts involved.

But despite all of the above, any application for Social Security can be affected by the amount you earn until you reach retirement age. Your cousin's job doesn't disqualify her for a survivor's benefit, but her salary might prevent her from collecting it.

Here's why:

Until your full retirement age, you can't collect Social Security if your earnings exceed an annual limit. In 2011, you forfeit $1 of benefit for each $2 you earn above $14,160. Let's say  your cousin's survivor benefit is $1,000 a month, or $12,000 a year. If she earns $38,160 a year -- $14,160 plus $24,000 -- she forfeits the entire $12,000 benefit until she turns 66.

In the year that you turn 66, you forfeit $1 of benefits for each $3 you earned above $37,680 prior to your birthday. Starting with your birthday month, you're home free. You can collect your full Social Security benefit regardless of how much you earn.

If your cousin's salary doesn't bar her from collecting a survivor's benefit at this time, she should go back to the Social Security Administration and ask them to revise their answer.  It wouldn't be the first time an applicant has been misinformed. (I've received letters from widows who were wrongly told they weren't entitled to more than a $250 'burial' payment!)

If she's earning above the annual limit, she should consider an alternative strategy:

She could postpone her application for the survivor's benefit until age 66, and switch to her own benefit at age 70. As I've explained in other posts, your own benefit grows 8% a year for each year you delay taking it between ages 66 and 70. At 70, your cousin's benefit based on her own work record will be one third bigger than it is when she's 66.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved