This post is the fourth in a series about the Death of the Stretch IRA. If you’re a new visitor to my blog, this post might not make much sense to you unless you back up and read the three posts, How will your Required Minimum Distributions Work After the Death of the Stretch IRA Legislation?, Are There Any Exceptions to the Death of the Stretch IRA Legislation?, & Will New Rules for Inherited IRAs Mean the Death of the Stretch IRA? immediately before this one. Those posts spell out the details of the proposed legislation that will cost your family a lot of money. If you’re familiar with the specifics of the legislation, then please read on, because I’m going to talk about some possible solutions to the problems that will be caused by the Death of the Stretch IRA.
What is the best way to protect my IRA, once this Stretch IRA legislation is passed?
Many people have asked me, “What is the best way to protect my IRA, once this legislation is passed? Well, the Senate Finance Committee did say that some people could be excluded from the new tax rules – my post of February 28th discusses them – so let’s look at how they might figure into your game plan.
I firmly believe in providing the surviving spouse with as much protection as possible, so I usually recommend that you name your spouse as your primary beneficiary and give him the right to disclaim your IRA to someone else. If your spouse needs the money, that’s great. He is excluded from the legislation, so he can still “stretch” your IRA after your death.
But suppose you have no spouse, or that your surviving spouse will not need your IRA because he has sufficient assets of his own? In that case, your IRA will likely go to your child or children. And the problem with that is that children are not excluded from these new rules unless they are disabled or chronically ill. So here is one possible solution that can protect your children from the harsh new tax structure.
Let’s assume that you have an IRA that is worth $1.45 million, and that your beneficiary is your child. Under the proposed new rules, your child can exclude $450,000 of your IRA and stretch it over the remainder of her life. The remaining $1 million, though, will be subject to the new rules and will have to be withdrawn from the IRA within five years. Even if she tries to spread the withdrawals out over five years to minimize the tax bite, she’ll still have to include about $200,000 in her income every year. Depending on her income from other sources, that will probably push her up into a higher tax bracket. The current maximum tax rate is 39.6 percent, so it’s possible that your child would have to pay $400,000 in federal income taxes – even more, if the state you live in taxes IRA distributions.
Can a Charitable Remainder Unitrust (CRUT) provide a possible solution to the Death of the Stretch IRA?
Can a Charitable Remainder Unitrust (CRUT) provide a possible solution to the Death of the Stretch IRA, and protect your child from these taxes? If you look at my post on February 28th, you’ll see that charities and charitable trusts are excluded from the five-year rule! And while the CRUT has to comply with certain IRS rules regarding how and when money can be withdrawn, the IRA that is inside the trust is not subject to tax UNTIL you take withdrawals from it. So if your child receives the minimum possible from the trust every year, it is possible that he can avoid much of the income tax acceleration that will happen once this legislation is passed.
Will your child have more money over the long term with the income from the $1 million that goes into the trust, or if he has to follow the new IRA rules and has to withdraw your IRA and pay taxes within five years, leaving him with an after-tax amount of about $600,000? I’ll answer like a lawyer – it depends. One of the very real problems with a charitable trust is that, once the beneficiary dies, any money that is left over goes directly to the charity. So if your child dies after receiving just one distribution from the trust, the charity will end up receiving more money from your IRA than your family will. There are some possible ways to manage this risk, though, such as taking out a term insurance policy on the life of your child. So if he does die prematurely, the proceeds of the life insurance can replace the money that will go to the charity.
For some people, a CRUT can be a bad idea. There is a cost to draft the legal documents, but that cost is nothing compared to the cost of maintaining the CRUT over the long term. The Trustee must file a tax return for the CRUT to show the IRS how much has been paid to the beneficiary. The CRUT’s tax return produces a form that has to be included with the beneficiary’s tax return, just like a W-2 or 1099, and the extra paperwork means a higher tax preparation fee for the beneficiary every year. My rule of thumb is that it’s not worth the money or headaches to establish a CRUT and name it as your beneficiary if your IRA balance is below $1 million.
I encourage you to watch this short video to learn more about the pros and cons of Charitable Remainder Unitrusts, and how they can be used to help shield your retirement savings from the Death of the Stretch IRA legislation. However, do not take action and establish a CRUT until the final legislation has passed. If you are using Lange’s Cascading Beneficiary Plan, the current Stretch IRA rules will produce a far more favorable result than the trust.
Please stop back soon,
For more information on this topic, please visit our Death of the Stretch IRA resource.