Debunking IRA Urban Legends

Investors in IRAs often need a reality check when it comes to these common misconceptions.

by Natalie Choate

It's time to drive a stake through the heart of some widely held but very mistaken beliefs about planning for retirement benefits.

The Myth: By leaving your IRA to a perpetual or "dynasty" trust that also qualifies as a "see-through trust" under the Internal Revenue Service's minimum distribution trust rules, you can obtain a perpetual stretch-out for your IRA, or (even better) a perpetual tax-free family investment pool with a Roth IRA.

The Reality: It's true that certain states now permit clients to establish perpetual or 1,000-year trusts. But leaving your IRA or Roth IRA to such a trust in no way lengthens the maximum payout period permitted under the Tax Code's minimum distribution rules--even if the trust does manage to qualify as a "see-through trust" under the IRS' "minimum distribution trust rules." The minimum distribution rules require that all benefits be distributed, beginning the year after the participant's death, in annual installments over the life expectancy of the designated beneficiary. The longest payout period possible under that rule is about 81 years (the life expectancy of a one-year-old beneficiary). So if the perpetual trust qualifies as a see-through, and the oldest beneficiary of the trust is a newborn baby, the payout period for the benefits will be about 81 years. The trust can last forever, but the IRA (or Roth IRA) payable to that trust cannot last beyond the life expectancy of the oldest trust beneficiary.

The Myth: We can get a perpetual stretch-out of our IRA death benefits by leaving them to an individual (say the participant's child), who at his later death leaves the account to a next-generation beneficiary (say the participant's grandchild), who at his later death leaves the account to the next younger generation (the participant's great-grandchild), and so on.

The Reality: Well, it's true that the original beneficiary can name a successor beneficiary for the account, and thus pass it on to, say, the original beneficiary's own child. And it's even true that each successor beneficiary can leave what's left of the account on such beneficiary's death to still another successor beneficiary. But no matter how many successor beneficiaries there are, the account will still have to be distributed over the life expectancy of the FIRST beneficiary--he is the original "designated beneficiary," and his life expectancy is the payout period for the inherited IRA regardless of whether he survives for that entire life expectancy or dies prematurely and passes the account on to a successor beneficiary. So you can see it is unlikely that the account will even exist past the life expectancy of the first beneficiary (because he will probably survive to his life expectancy and therefore he will withdraw 100% of the account). It is extremely unlikely that the account will exist for multiple generations--that would require that each successive generation of beneficiaries dies within the life expectancy of the original beneficiary.

The Myth: The client can leave his retirement accounts to a "conduit see-through" trust for the benefit of his surviving spouse. During the surviving spouse's overlife, the applicable distribution period will be the surviving spouse's life expectancy. When the spouse ultimately later dies, the remaining benefits can be paid to the children over the life expectancy of the oldest child.

The Reality: No they can't. When retirement benefits are paid to a trust, if the trust qualifies as a see-through trust, the applicable distribution period is the life expectancy of the oldest trust beneficiary (the surviving spouse in this example). Even if the trust is the special type of see-through trust known as a "conduit" trust, there is no way for the trust to "flip" over to using the children's life expectancies as the applicable distribution period for benefits remaining in the plan at the surviving spouse's later death. By the way, it's very unlikely there will even be anything left in the retirement plan at that point--that would happen only if the spouse did not survive for her entire life expectancy.

If you want the payout period to "flip" to the children's life expectancy at the death of the surviving spouse, there's only one way to get that result: Leave the retirement benefits outright to the surviving spouse, and she rolls them over to her own IRA. By doing that you eliminate the requirement of distributing the benefits over the spouse's life expectancy (instead, she can defer all distributions until she reaches age 70 1/2, then withdraw using the Uniform Lifetime Table, which is much more favorable than a payout over her single life expectancy). At her death, she can leave the remaining balance of the rollover IRA to the children as her designated beneficiaries. As designated beneficiaries, they will qualify for a payout over their life expectancies.

All of these myths arise out of forgetting the basic bedrock principle of the minimum distribution rules: The retirement plan account cannot stay in existence longer than the life expectancy of the original owner (the participant) and his or her designated beneficiary. The money doesn't all have to be spent; the participant and beneficiary can save and invest the distributions they receive (after paying taxes on them, of course, in the case of non-Roth accounts). But at the end of that Code-mandated payout period, all of the money must be out of the plan.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed in this article are the author's.

Rollover IRAs Offer a Wide Range of Benefits

IRA assets can generally be divided among multiple beneficiaries in an estate plan.

As compared with employer-sponsored retirement accounts, a rollover IRA can provide you with the broadest range of investment choices and the greatest flexibility for distribution planning. Also, a rollover IRA can typically be operated with fewer restrictions. This brief overview highlights some of the key benefits of a rollover IRA compared with an employer-sponsored plan.

• More control: As the IRA account owner, you make the key decisions that affect management and administrative costs, overall level of service, investment direction, and asset allocation. You can develop the precise mixture of investments that best reflects your own personal risk tolerance, investment philosophy, and financial goals. You can create IRAs that access the investment expertise of any available fund complex, and can hire and fire your investment managers by buying or selling their funds. You also control account administration through your choice of IRA custodians.
• More flexibility: IRAs can be more useful in estate planning than employer-sponsored plans. IRA assets can generally be divided among multiple beneficiaries in an estate plan. Each of those beneficiaries can make use of planning structures such as the Stretch IRA concept to maintain tax-advantaged investment management during their lifetimes. Beneficiary distributions from employer-sponsored plans, in contrast, are generally taken in lump sums as cash payments. Also, except in states with explicit community property laws, IRA account holders have sole control over their beneficiary designations.

Efficient Rollovers Require Careful Planning
One common goal of planning for a lump-sum distribution is averting unnecessary tax withholding. Under federal tax rules, any lump-sum distribution that is not transferred directly from one retirement account to another is subject to a special withholding of 20%. This withholding will apply as long as the employer's check is made out to you -- even if you plan to place equivalent cash in an IRA immediately. To avert the withholding, you must first create your rollover IRA, and then request that your employer transfer your assets directly to the custodian of that IRA.

Keep in mind that the 20% withholding is not your ultimate tax liability. If you spend the lump-sum distribution rather than reinvest it in another tax-qualified retirement account, you'll have to declare the full value of the lump sum as income and pay the full tax at filing time. In addition, the IRS generally imposes a 10% penalty tax on withdrawals taken before age 59 1/2.

Also, if you plan to roll over the entire sum, but have the check made out to you rather than your new IRA custodian, your employer will be required to withhold the 20%. In that event, you can get the 20% refunded if you complete the rollover within 60 days. You must deposit the full amount of your distribution in your new IRA, making up the withheld 20% out of other resources. When you file your tax return for the year, you can then include a request for refund of the lump-sum withholding.

If you have after-tax contributions in your employer plan, you may opt to withdraw them without penalty when you roll over your assets. However, if you wish to leave those funds in your retirement account in order to continue tax deferral, you can include them in your rollover. When you begin regular distributions from your IRA, a prorated portion will be deemed nontaxable to reimburse you for the after-tax contributions.

Potential Downsides of IRA Rollovers

While there are many advantages to consolidated IRA rollovers, there are some potential drawbacks to keep in mind. Assets greater than $1 million in an IRA may be taken to satisfy your debts in certain personal bankruptcy scenarios. Assets in an employer-sponsored plan cannot be readily taken in many circumstances. Also, you must begin taking distributions from an IRA by April 1 of the year after you reach 70 1/2 whether or not you continue working, but employer-sponsored plans do not require distributions if you continue working past that age.

Remember, the laws governing retirement assets and taxation are complex. In addition, there are many exceptions and limitations that may apply to your situation. Therefore, you should obtain qualified professional advice before taking any action.

© 2011 McGraw-Hill Financial Communications. All rights reserved.

 This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by James P Ellman, ChFC and Barry Mendelson, CFP, local members of FPA.