IRA tax planning is the subject of many articles and indeed diverse opinions. This is true for one’s lifetime IRA planning, but perhaps nowhere more acutely than in the area of designing a post-death distribution plan. This, in and of itself, reflects there is no easy fix, no black and white answers. Rather, this planning depends on one’s family structure, and most notably even, one’s priorities in viewing the planning for one’s children and grandchildren.
Aside from IRAs, the classic advice given by estate planning attorneys for clients of means is to consider establishing trusts for their adult children at death. Consider Jane and John Doe “GEN 1,” with adult children, Gillian and Brandon “GEN 2,” each themselves with two children of their own “GEN 3.” The senior Doe’s may have as a priority that the grandchildren receive whatever is left of the senior’s estate once Gillian and Brandon die. In addition, they wish to protect the inherited property from any divorce or creditor claims of their children (or of a spouse of a child). These are non-tax priorities, which are readily addressed by establishing trusts in the Wills of GEN 1. Yet a good estate planning attorney will point out that trusts introduce a layer of complication to one’s estate plan. They require a separate investment account and separate trust income tax return, annually. On top of that, trust income tax rates are generally equal to the highest income tax bracket (the “tax issue”); this tax rate is applied to the interest and dividends only, and only if those items are not distributed to the beneficiary in the year earned. Jane and John consider these factors and decide the trusts are “worth it” to them, on balance. They are deciding that the non-tax priorities outweigh the tax issue, on balance.
Now they must consider whether their IRA (and 401k) assets should be included in the trust planning OR excluded from the trust planning. Why would they consider treating the IRAs differently? This revolves around the fact that generally all of the IRA funds (not just interest and dividends) are income taxable to their heirs. If GEN 1 leaves the IRA outright to GEN 2, then generally speaking, GEN 2 has 10 years over which to withdraw and pay income tax on the IRA funds – at their own income tax rates.
Whereas, if GEN 1 leaves the IRA to trusts for GEN 2, then the same 10 year period “may” be achieved (by special Will drafting), but the trusts generally pay income tax at the highest tax bracket (the “IRA tax issue”). So, Jane and John’s initial reaction is to recoil from including the IRA in their trust planning. They want to give their children the benefit of using the GEN 2 income tax rates, rather than the highest tax rate applicable to trusts. The planner reminds them to balance the IRA tax issue with their non-tax priorities. How worried are they about their children being exposed in a divorce or creditor lawsuit? And how concerned are they that their child will bequeath the [remaining after-tax] IRA funds at such child’s death to someone other than GEN 3 (such as GEN 2’s spouse)? If they are not concerned about these issues, then Jane and John should indeed leave the IRA (and quite possibly the other assets in their estate) to GEN 2 outright.
Whereas, if Jane and John are concerned about the non-tax issues, they must ponder whether it is “worth it” to them to achieve their non-tax priorities, despite the IRA tax issue. This may well depend on the particular family dynamics of Jane and John. It is likely also dependent on the size of the IRA relative to the rest of the estate. Having said this, we have seen very similarly situated clients diverge on their strategy. Some people value simplicity over all else, and others value as many protections as possible. We find however that most people fall somewhere in the middle.
As you “ponder” which approach is right for you, keep in mind there are ways (if your heirs stay informed) to mitigate the IRA tax issue, even with trusts. Say Jane and John die, leaving Gillian 50% of the IRA, in trust for her and her children ultimately. Gillian has 10 years to pay tax on the IRA via the trust. Say the trust allows discretionary distributions to Gillian that authorize her to receive enough of the IRA to “soak up” her lower income tax brackets. She receives those amounts from the trust, taxed at her rates (“Gillian’s portion”). The rest of the IRA stays in the trust (the “trust’s portion”), taxed at its [highest] tax rate (but that would have been her tax rate on that portion in any event). Yes, Gillian’s portion no longer enjoys the benefits of the non-tax priorities of GEN 1, but at least the trust’s portion does enjoy the benefits of the non-tax priorities.
So, what’s the right answer, leave the IRA outright to your children (simplicity) or in trust for them (to achieve your non-tax priorities)? Well, as lawyers are want to say, “IT DEPENDS.” Yes, it depends on YOUR goals and where you fall on the spectrum between simplicity and protections; and add to that, can YOUR children tolerate/handle the more complicated approach or not?
There’s no magic pill in life. But it is certainly better to choose between options in an informed manner than be uninformed in the choice you are making.