Lynn Brenner's Family Finance

Who Inherits an IRA That's Going Into a Trust?

Q: My dad, who has no Internet connection, asked me to ask you this question: Who will get his IRA if he passes? He is 88 years old, and has a living trust set up. I'm his oldest son and he has given me the executor role. He just read your article in the March-April 2010 issue of AARP magazine ('Who'll Get Your IRA?") that has given him some concern on how to handle the IRA. -- GL via email

 

A: If the IRA goes into the trust, the trust beneficiaries will get it. But how fast it must be distributed -- and taxed -- depends on how the trust is written.

First, a basic fact that's often misunderstood. The legal document that controls who gets your IRA is your beneficiary designation form. When someone says he is leaving an IRA `to my will', or 'to my living trust', he means either that he didn't fill out the IRA beneficiary form at all, or that he used the form to name his will or his trust as the beneficiary.

In either case, the result is that he has made his estate his IRA beneficiary. His will (or his living trust) directs how his estate is to be distributed.

It sounds as if your father has left his IRA to his living trust. And that creates a potential problem:

When you name a human being as your IRA beneficiary, that person can stretch withdrawals from the account over his or her own life expectancy. If your heir has a long life expectancy, that stretch-out can make a huge difference to the size of his or her inheritance.

Let's say you leave a $400,000 IRA to a 40-year-old, for example. He can stretch his required annual withdrawals from the account over another 43.6 years. (His first required minimum distribution would be $9,174 —$400,000 divided by 43.6.) He'd owe taxes on the withdrawals, but the IRA balance could keep growing untaxed for more than four decades.

Assuming an 8 percent annual return and minimum annual withdrawals, by the time he turned 65, the IRA would be worth almost $1.2 million, says Barry C. Picker , a Brooklyn NY IRA expert -- and in the meantime, he would have received $671,000 in annual distributions!

But it's a different story when you name a non-human beneficiary. Legally speaking, your estate expires when you do. It has no life expectancy, so it can't stretch out its withdrawals from the IRA. Instead, the IRA must be emptied within five years of your death, or on a schedule that's based on your remaining single life expectancy according to the Internal Revenue Service actuarial table -- depending on the age at which you died. (The five year rule applies if you were under 70 and a half when you died. The IRS single life actuarial table applies if you were over 70 and a half when you died.)

Either way, the IRA must be emptied much faster than if your kids were using their own life expectancies.

You can avoid this problem if the trust is worded properly. If it's written right, for tax purposes it becomes only a conduit to the human trust beneficiaries.  In that case, the IRA can be emptied over the life expectancy of the oldest trust beneficiary.

But your father doesn't have to worry about whether his trust is correctly worded.

There's a simple, cost-free way for him to make sure his IRA beneficiaries inherit the account in the most advantageous way. All he needs to do is to name them on his IRA beneficiary form. If he has already named his living trust, he can ask the IRA custodian for a new form and can change his beneficiary designation.

When your heir is a disabled or minor child who'll need help handling his inheritance, it makes sense to leave your IRA to a correctly worded trust (and to name a reliable trustee.) But otherwise, using a trust as your IRA beneficiary doesn't really provide any advantage -- and if it isn't done correctly, it could inadvertently hurt your survivors by making the IRA taxable much faster than necessary.

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

(c) Lynn Brenner, All Rights Reserved.

 

       

Don't Leave Money to a Disabled Child Directly -- Leave it to a Special Needs Trust!

Q: Recently, my father passed away.  He named all six children to inherit his estate.  One of our siblings is a ward of the state due to a disability. How can we handle her portion to ensure that the she receives  income without her misusing the funds, and in a way that will shelter her inheritance from taxation?

What is the government's position regarding wards of the state receiving inheritances? Under the program that my sibling is in, she cannot have more than a certain amount in her bank account without becoming ineligible for the program. -- BC via email



A: This is a very sad situation. Based on what you say, your sister will lose her inheritance. The only silver lining is that, as a result, she'll remain eligible for government assistance.

Income taxes aren't an issue here; with few exceptions, inherited assets aren't subject to income tax. The problem is that the heir is receiving government assistance, probably from Medicaid.

Medicaid is a needs-based government program that helps people who are poor and/or disabled. Medicaid is a joint federal and state program, and its rules differ from one state to another. But in all cases, you're ineligible for assistance if your income and assets exceed a very small amount that is set by state law.

Your story is a cautionary one for other readers. Parents and grandparents who want to leave money to a disabled child should never leave it to the child directly because that can jeopardize his or her government benefits.

Your sister's share of the inheritance should have been left to a Special Needs Trust for her benefit. This type of trust should be prepared by an attorney who specializes in elder law. It's very carefully designed to pay only for things that government programs don't cover. As a result, the trust beneficiary remains eligible for government assistance.

There's little your family can do at this point. You could petition the court that probates your father's will to change its provisions, says Donald Hecht, an elder law attorney in Garden City, N.Y.  But this course isn't worth considering for anything but a very substantial inheritance because it would require costly legal help. And it's a long shot even if you can afford it. "This kind of petition is very very rarely granted," he says. "You'd have to present clear and compelling evidence to the court that the will as written was not Dad's proven intention."

You say that your sister is a 'ward of the state.' That's not a legal term, says Hecht, but it sounds as if she may be a permanent resident of a psychiatric hospital.

Depending on the state, and on the beneficiary's age, Medicaid's rules are sometimes more lenient in other settings. When someone in a nursing home inherits money, for example, the inheritance will disqualify him or her for future assistance until it is spent down, but Medicaid won't always seize the money to recoup its past assistance. By contrast, Hecht says that Medicaid is often extremely aggressive about collecting any money available to its beneficiaries who are in mental health facilities. "But if the state grabs the money in this case," he adds, "at least your sister won't lose her eligibility for the program."

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

How Will I Be Taxed When I Sell Inherited Property? What's My Cost Basis?

Q: My parents deeded land to me and my siblings 10 years ago, keeping a life estate in the property reserved for themselves. Our last surviving parent died in November of 2009. We're trying to figure out how we will be taxed when we sell this land. I've had conflicting answers about what we should use as our cost basis. Some tax accountants have said we must use the original purchase price, and others say we can use the value of the property last November when our mother died. Which is correct? -- KF via email

A: Your cost basis is the market value of the property at the time of your mother's death last November.

In tax jargon, your cost basis for this property is 'stepped-up' to its market value.This means that if the land was worth $5 million last November -- why not use a nice fat hypothetical number? -- you can sell it for $5 million without incurring any capital gains tax.

By contrast, if you had to use the original purchase price as your cost basis, you'd owe a tax on the difference between your sale price and what your parents originally paid for the land. So if they'd bought it for $100,000 and you sold it for $5 million, your taxable profit would be $4.9 million.

Quite a difference, isn't it?

But as I'll explain in a moment, people who inherit assets from someone who dies in 2010 can't use the above example as a guide.   

That's because the rule in question is based on the relationship between two different taxes. One is the capital gains tax, which is the tax on your profit when you sell an asset that has appreciated in value since you acquired it. The other is the federal estate tax, which is the tax levied on assets that you bequeath to your survivors -- and as of January 1, we don't have a federal estate tax.

The longstanding rule is that heirs get a 'stepped-up' cost basis on assets that are subject to estate tax. This is true even if the estate in question is actually too small to owe any estate tax.

The practical result is that people have long enjoyed a stepped-up cost basis on most inherited capital assets. (I say 'most' because of course there are important exceptions. You never get a step-up on any asset that is inside a tax-deferred retirement account, for example.)

Because your mother kept a retained life estate in this property, 100% of its value is included in her taxable estate. Therefore you inherited it at its stepped-up cost basis. As I explained in an earlier post, even tax professionals sometimes get this wrong; that's why you've heard conflicting advice about it.

But Congress let the estate tax law expire on December 31, 2009.  Remember, you only get a step-up on inherited capital assets that are subject to estate tax. Because there is no federal estate tax at the moment, there's no step-up on inherited capital assets.

The good news for most people is that there is an exemption. "Each estate is entitled to a $1.3 million aggregate basis step-up, and a $3 million spousal step-up," says Bernard A. Krooks, a New York estate and elder law attorney.  

This means that a person who isn't married can still leave $1.3 million in assets that will qualify for the step-up. Someone who is married can leave $1.3 million of assets that get the step-up, plus an additional $3 million of assets to his or her spouse that will qualify for the step-up.

But the above exemptions don't apply to property in which the decedent had retained a life estate.  If your mother had died last week, you wouldn't get the step-up on your inheritance. The current situation is temporary, however. There's little doubt that the federal estate tax will be reinstated, probably later this year. When that happens the unlimited step-up will return.

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

Don't Make Your Estate Your IRA Beneficiary

Q: My mother had an IRA and the IRA beneficiary is her estate.  However, her will leaves everything, including the IRA, equally divided between my sister and me.  Since we were not the actual beneficiaries on the IRA, what is our best course of action to reduce tax exposure?  I’ve seen a lot of documentation on how to handle an IRA if you are the beneficiary, but since the estate is the beneficiary, the attorney handling her will says it makes a difference to us. -- CS via email


A:   Your lawyer is right. The rules are different when the estate is the IRA beneficiary.

In fact, there are three sets of rules for inherited IRAs. The first applies only to beneficiaries who are surviving spouses. The second applies to all non-spouse human beneficiaries -- i.e., children, siblings, friends. And the third applies to non-human beneficiaries like estates and charitable organizations.

A surviving spouse can transfer an inherited IRA into an IRA in his or her own name, and thus postpone taking taxable distributions from the account until after turning 70 and a half.

But no other heir can transfer your IRA into a new account in his or her own name. They must start taking distributions after your death. The big question is, how fast must they empty the account? A lot of money rides on the answer, since the longer they can postpone taking money out of the IRA, the longer it can keep growing untaxed.

If the designated IRA beneficiaries are human beings, they can take minimum annual distributions based on their own life expectancies. But in your case, the IRA beneficiary is your mother's estate -- and it has no life expectancy. The result: 

If your mother was under 70 and a half when she died, her IRA must be emptied within five years of her death. If she was older -- and therefore already taking mandatory IRA distributions -- you and your sister can empty the account over her remaining life expectancy, as defined on the Internal Revenue Service 'Single Life' actuarial table for IRA owners. You'll find that table in the index of IRS Publication 590, which you can download at www.irs.gov.

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