Is it better to inherit a stretch IRA or taxable funds?
I’ve been working on both mine and my Dad’s portfolios. I’ve gotten a lot of great help on the Bogleheads forum for both portfolios, but have a nagging issue with my Dad’s trust. It was suggested on that forum, that I post this issue for some help on the Ed Slott IRA forum.
My sister and I are now co-trustees on our Dad’s trust and POA on his IRA. Our Dad would like to provide lifetime income for his four heirs. However, at least one of his heirs does not want any increase in income because she is already in the highest tax bracket and lives in California. She would lose nearly half of this income to taxes and would prefer to receive funds and not increase her income. The other heirs are in the lower tax brackets. Two heirs have not saved well and this potential income will make a big difference for them. These two heirs have spendthrift spouses, one of which, has already caused the couple to file for bankruptcy. The fourth heir is indifferent as to how s/he receives this inheritance.
Thus, we are considering leaving the IRA funds (as a stretch IRA) to two, possibly three heirs and splitting up the taxable to create an equal dollar division. This way, two or three heirs receive lifetime income from the IRA and less taxable funds and one or two heirs receives all or mostly taxable funds.
We have met with the estate attorney and CPA and have gotten differing opinions. The attorney says that we can do whatever we want and the wording in the trust already gives us this power. We would just need to change the beneficiaries on the IRA to whomever is going to get those funds. Right now, all four heirs are listed.
The CPA says the best way to handle the division of assets is to set up one trust for each heir and let an institutional trustee (it would be Vanguard, if that’s the case) manage the payouts to offset the taxes created with the increase in income.
My Dad is completely opposed to setting up four trusts. He is only open to setting up inherited IRA trusts (spendthrift trusts?) for the two heirs. He wants his trust to go away after the funds are distributed. My sister and I agree, but the CPA said “forcing” the heirs to take income from the IRA could be construed as unfair. My understanding is that if one inherits an IRA, one must take distributions and the best way to avoid a “blowout” is to stretch the IRA. There is no way to avoid taking distributions.
Another option that we are considering is selling the taxable portion to fund SPIAs for the two heir to protect them from liquidating those assets as well.
Before we start paying for more opinions, I thought I would ask this forum what they thought. Dad’s IRA is just over $1M and the taxable portion is about $2M. I’m not expecting legal advice, just some more noodling on this perplexing issue.
Permalink Submitted by mk foss on Wed, 2009-12-23 02:37
This is not completely answering your question but giving you something to think about.
I was on a panel a number of years ago with an attorney who was expert in IRA and estate matters. Someone asked this question: Two heirs must split the estate 50-50. One of them will get the IRA. Should that heir receive some nonIRA funds to make up for the fact that they’re receiving an asset that has income taxes associated with it. The expert indicated that if he were given the choice he would take the IRA even though there were income taxes associated with it because the tax free growth would make up for the fact that you were paying income taxes on the RMDs. Given that, I wouldn’t consider potential income taxes on the IRA as part of the decision making process.
I’m not sure how the trust agreement would handle everything as the attorney says that it would. If the IRA beneficiaries were changed to those inheriting the IRA, the trust agreement would need some provision that the IRAs must be considered when dividing the trust amongst the heirs. If you have that language, I’d agree with the attorney. Without it, an aggressive beneficiary could claim the IRA where they’re named as bene plus one-fourth of the balance.
The stretch IRA is definitely beneficial but heirs (especially those with spending problems) are unlikely to take only the Required Minimum Distributions. To ensure that only the RMDs are withdrawn, you would need a trust for the spendthrift heir to prevent an immediate cash out of the fund. Whether you use Vanguard for a trustee or name a family member isn’t as important as making sure the trust agreement is flexible enough to allow for a greater distribution than the RMD in case of some unexpected expenses.
Alan or Bruce will probably have their own ideas.
Permalink Submitted by Bruce Steiner on Wed, 2009-12-23 23:00
The key here is that Dad has to focus on the issues and be willing to do what will benefit his children. Will he at least let you work out what makes the most sense? Why is he willing to create trusts for the IRA which is only 1/3 of his assets, but not for his other assets which are 2/3 of his assets? Why is he willing to create trusts for two of his children but not all four?
Our clients generally provide for their children in trust rather than outright, to keep the inheritance out of their children’s estates for estate tax purposes, and to better protect the inheritance against the children’s potential creditors, including spouses. In this case, in addition, two of the children need to inherit in trust to protect against themselves.
Leaving the assets non pro rata is interesting. I agree with Mary Kay (or the lawyer who on the panel with her) that given a long enough time frame, the benefit of the stretchout may offset (or even more than offset) the cost of the IRA being pre-tax.
There are lots of things for Dad to discuss with his lawyer: (i) trusts for all four children, (ii) the degree of control each child should have over his/her trust (for example, the more responsible ones might have a greater degree of control over their trusts than the less responsible ones), (iii) the trustees of each child’s trust, (iv) Roth conversions (particularly since Dad has the money to pay the income tax on the conversion), (v) converting all at once versus spreading the conversion out over a number of years to avoid bunching the income.
Investing the taxable assets in annuities is likely to be far more costly than paying for advice.
For more on trusts as beneficiaries of retirement benefits, see my article on that subject in the March 2004 issue of the Estates, Gifts & Trusts Journal: http://www.kkwc.com/bio.php?r=30.
Bruce Steiner
Permalink Submitted by charles lore on Sat, 2009-12-26 17:34
SPIA’s are typically sold and not bought. THe internal rate of return, even with period certain and or refund provisions , is horrible. The only way a good return can result is if the annuitant lives far beyond life expectancy. The salesman will counter by say the you can never out live the income. THis may be true but there is a great opportunity cost of SPIA;s.
Permalink Submitted by Al Fry on Sat, 2009-12-26 22:03
Of course SPIAs can also be variable, with a guaranteed floor.
Permalink Submitted by Lesley Sheppard on Sun, 2009-12-27 01:31
Mary Kay Foss, Thank you for your post. I believe that this wording is in the trust, but we will certainly make sure. Great point.
Bruce Steiner, Thank you for posting. We will be meeting with the attorney again next week. We will ask him about the concept of four trusts. This goes against what my dad wants, but worth looking into. Right now, he is only willing to set up an inherited IRA trust for each of the two daughters with problem husbands. Good point about the Roth conversion. We are looking into this as well as Dad will qualify to convert next year.
Chuck Lore, Thank you for your comments on the SPIA. We are leaning against this insurance product, with one exception we are exploring. My dad has six Vanguard variable annuities that are the result of other insurance products rolled over to Vanguard. We are considering converting these to two SPIA for the two daughters in question. We could try to split them four ways, but it would be a hassle. We are allowed to combine them if we convert them to SPIAs. These comprise about 8% of the inheritance portfolio.
Altry, Thank you for the information. We will look into this type of SPIA, should we go this route.
Thanks again for all of the help!