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Inheriting IRAs and Roth IRAs
James Lange, CPA/Attorney
Guest: Michael J. Jones, CPA
|Click to hear MP3 of this show|
- Guest Introduction: Mike Jones
- IRA Beneficiary Forms
- To “Trust” or Not to “Trust”
- Inherited IRAs
- Disclaimer Planning
- Protecting Spendthrift Beneficiaries
- Stretch IRAs
David Bear: Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks. I’m David Bear, here in the KQV studio with James Lange, CPA/Attorney, and author of three bestselling books: Retire Secure!, The Roth Revolution, and Retire Secure! For Same-Sex Couples. People who spend a lifetime accumulating significant retirement asset portfolios generally pay plenty of attention to their assets. Those who inherit those assets are often less familiar with how to manage them. The ultimate value of any IRA or Roth IRA depends on how well informed the beneficiaries are, but too many wind up with only a fraction of what they might’ve received. For insights on the problem and solutions, we welcome Mike Jones, CPA, nationally-known tax expert and author of Inheriting an IRA: How to Create a Lifetime of Paychecks. Based in Monterey, CA, Mike’s tax consulting practice focuses on estate and retirement planning, wealth transfer strategies, trusts and probate matters and family business transitions. Among other issues, he and Jim will discuss how to get the most from an inherited IRA or Roth IRA, including tax rules to follow when opening them and transferring assets. They’ll also look into the potential end of the stretch IRA, and the huge impact that will have on inherited assets. So, stay tuned for an interesting and informative hour, and without further ado, welcome, Mike and hello, Jim.
Jim Lange: Welcome, Mike.
Mike Jones: Thank you.
Jim Lange: So, the three top people, at least measured in terms of books sold and speaking fees in the country for being an IRA expert, I think are fairly unquestioned: Ed Slott, Bob Keebler and Natalie Choate. All three of them have given glowing testimonials to Mike Jones’ new book, Inheriting an IRA: How to Create a Lifetime of Paychecks. By the way, this is not one of those that you should actually think about, and I know we have advisors all over the country, mainly local people, but also people from all over the country also. Whether you are an advisor or whether you are an IRA owner, this is a really important book that you should get. It’s called, again, Inheriting an IRA: How to Create a Lifetime of Paychecks,” and there are two ways to get that book: one, the easy way (if you don’t want to have to think), go to Amazon, type in inherited IRA, type in Jones, you’ll see the book and you can just buy it. The other way to do it is inheritinganira.com. By the way, it’s impossible for you not to get the value from the book, and if you buy it on my recommendation and you don’t get the value, I will personally refund your money.
David Bear: Ha ha!
Jim Lange: Anyway, that’s sincere. I mean, it’s a good book. You know, in the IRA expert world, there are maybe ten or fifteen guys who really know what they’re doing and have written well, and Mike’s one of those guys, and he’s done a terrific job, and to me, even though the book would be of extreme value to beneficiaries of IRAs, I think probably it’s of greater value, at least for right now, to people who are doing their estate plans. So, Mike, if I can start with a couple basic questions. I’m guessing Pittsburgh’s a working class town. We’re not silver spoon kids. You know, so we built up our money by working hard for twenty, thirty, forty years, putting money in our retirement plans, and a lot of us have more money in our IRAs and retirement plans than somewhere else. Why is it so important to properly plan for the disposition of our IRAs? Why not just put it in with the rest of the will and not think about it? Why are IRAs such a special area that demands such specialized attention?
Mike Jones: Sure, and thanks for asking. There are two main reasons that I think about when you ask me that question. One of them is that the beneficiary form, and when you talk about the retirement money that we’ve all accumulated, it’s hopefully going to wind up in an inherited IRA. It could start out in your employer plan, which could still be sitting there even after your retirement. So, you could have an account in a retirement plan from an employer that could go to an inherited IRA, or you may have moved your money from your employer’s plan into your own IRA. Either way, the ultimate destination of those monies when you pass on is going to be controlled by a beneficiary form that you get from your IRA custodian or from your plan administrator. If you fail to fill out that form, you may, first of all, make it very confusing as to who’s entitled to that, because that then may go to your estate, and that may not be the result that you want. Secondly, when you actually name the correct beneficiaries on the form, they get the ability to stretch those distributions out over their lifetime. They do not get that ability if it goes through an estate first.
Jim Lange: All right. So, let me reiterate one thing that you said that I think is critical, that people don’t necessarily understand. It is not the will that controls the disposition of the IRA. It is specifically the beneficiary designation of the IRA. Is that right?
Mike Jones: That is correct.
Jim Lange: Well, that’s critical because a lot of times, people come into my practice and they have these twenty, thirty, forty page wills, and I say, “That’s great. Where’s all your money?” And they say, “Well, ninety percent of my money’s in my IRA.” And I say, “Well, can I see the beneficiary designation of the IRA,” and I get this blank stare. But that’s actually the critical document.
Mike Jones: Yes, it is! Most who have those plans basically have two assets: the retirement money and the house.
Jim Lange: Well, we sometimes joke that a lot of my clients have between $500,000 and $2,000,000 in an IRA or retirement plan, a house and a Honda, and that’s it. And then, some joker says, “No, I have a Toyota!” But I think that, for those people, this is particularly important. You mentioned an inherited IRA and you mentioned stretching the IRA, and let’s not forget the spouse in between. Actually, first, why don’t we do that? Why don’t we first talk about what happens if you die and you are married?
Mike Jones: So, that, of course, is the most common thing that we are seeing today, is that the individual who accumulated the retirement money dies, and then that goes to the surviving spouse. Again, it really works best if the IRA beneficiary form says that it goes to the surviving spouse, so that you do not have to go through an estate first. The surviving spouse can do one of two things: the surviving spouse can move the decedent’s IRA into her inherited IRA, or alternatively, she can move it into an IRA in her own name and treat it as her own. Most commonly, we treat it as her own because the distributions will come out more slowly there than not. However, if that surviving spouse in under age fifty-nine and a half and makes the rollover to an IRA of her own, she’s exposing herself to a ten percent penalty for taking money out before she reaches age fifty-nine and a half. So, you really want to think carefully about which of those two options you’re going to do.
Jim Lange: Have you ever split the difference on that one? Like say, take some money, put it in the inherited IRA so she has some access to it before fifty-nine without a penalty, and then take the rest and put it in a traditional IRA?
Mike Jones: Yes, we have done that.
Jim Lange: That’s a slick maneuver, by the way!
Mike Jones: Yeah, thank you. We’ve done that, and what we’ve done is we’ve sent the surviving spouse to a financial planner and said, “What do you think you’ll need before you’re age sixty?” And there are some question marks there, so we might err a little bit on the side of an inherited IRA. But those distributions don’t have to start until the decedent would have turned age seventy and a half, so you may have quite a bit of wiggle room there anyway. So, it’s true. It’s good to split that up, and then what we felt that she could get her hands on, we left it in an inherited IRA, and what she wanted to make sure that she left for later and have a disincentive from taking money out, we rolled that over so that now that it’s her own IRA, she wouldn’t be exposed to that fifty-nine and a half ten percent penalty.
Jim Lange: Right, but just to clarify: if she is over fifty-nine, there isn’t any reason why she shouldn’t just treat it as her own IRA. Is that correct?
Mike Jones: If she’s over fifty-nine and a half (that ‘half’ is important), then she can do that. It’s funny. The actuarials deal in half years. I don’t know why that is, but all the tables look at half years.
David Bear: I wanted also to ask about another issue because not only is it important to have beneficiaries designated, but I know that it’s important to keep that updated because I can think of a couple of cases recently where there was a case where money had been left in an IRA, and the spouse died, and the secondary beneficiaries had trouble because the designation hadn’t been updated on the decedent’s IRA.
Mike Jones: That’s very true, and you find out that if the address doesn’t match, or the Social Security number doesn’t match or something like that, you can have trouble getting access to the IRA. I recently was involved in a case where nobody was even notified that the beneficiary existed because the beneficiary’s address had changed and they had moved on, and it wound up where things end up when you don’t claim property. After seven years (at least in California and I know in some other states as well, most other states if not all of them), if you don’t claim property after a certain number of years, it becomes the property of the state, and you have only so much time to find out that you have property with the state, and you have to go claim it. Fortunately in the case I’m dealing with, we did find out that the asset was sitting out there. We did get it back from the state, and now we had to make up required minimum distributions for past years and ask the IRS to let us out of the fifty percent penalty for not making distributions. So, yes. It is a huge mess if you don’t keep those beneficiary forms up to date.
David Bear: And we did have a couple of questions from readers that they submitted, maybe we can ask those at the moment? The first one came from a client of Jim’s. He said, “I have an IRA trust, one for myself and one for my bride, planning to update all this in spring 2015. Is there a better or simpler way than multiple trusts to provide annuitized money to adult kids?”
Mike Jones: There may be a simpler way, but the key word there is ‘annuitized.’ And by that, we want to be able to use those stretch distributions over a lifetime. The benefit of using a trust, and there are two big benefits to using the trust: one of them is that the beneficiary of the trust can’t simply swoop in and take all the IRA money out at once and use it to buy the new Honda or Toyota. Excuse me for whoever I’m offending on that point! So, that’s one big reason to have a trust is to meter the money, and therefore the taxation or the use of the money because stretch out is so very valuable, and I understand we may talk about that a bit more later why that is.
David Bear: Yes.
Mike Jones: Let me give you the other really important reason to consider using a trust in this day and age.
David Bear: Okay.
Mike Jones: It’s very recently been established by the Supreme Court that when you leave money to an inheritor, they don’t necessarily get very good bankruptcy protection. And so, if you’re concerned about providing creditor protection for your children or your spouse, that’s another very, very strong reason to set up a trust to be named as the beneficiary. And having said all that, trusts that have IRAs need to have special trust provisions. So, you need to find someone who understands what provisions need to be in that trust and make all that work out.
David Bear: That certainly makes good sense. Mary has a question. She says, “Should my trust be named beneficiary of my IRAs? Currently, my children and grandchildren are.”
Mike Jones: Again, for the reasons that I just mentioned, you might consider that. It sort of depends on how big that IRA is. If they’re getting a few thousand dollars, that’s one thing. But if they’re getting $40,000 or $50,000 or more, or maybe $100,000, it could be another thing. The best person to have that conversation with is probably your trust attorney, to talk about whether it’s cost effective to achieve the goals of making sure that you get stretched distributions, and also that you get creditor protection.
Jim Lange: But I will chime in on that question. One of the problems, and I think Mike sees this as a CPA, because a lot of attorneys, as soon as they see any potential trust situation, they go, “Oh boy!” And then, we draft these long complicated trusts, and then, you know, let’s say it’s funded with $5,000. Between the aggravations, now we have a trustee…I tend to use private or family trustees, but between the trustee, now we have to do an extra tax return for the trust. Then the trust typically will throw off a K-1 for the beneficiary. You have to figure…I don’t know. What would you say, Mike? Three to five hundred dollars extra accounting every year? So, if you’re just doing this for a couple thousand dollars, or even ten or twenty thousand dollars, I don’t necessarily think that’s the best way to go. Now, if you’re talking about a couple hundred thousand dollars, then it’s very often mandatory.
Mike Jones: Yes, your comments are in line with what I said just before you got back on, so thank you.
Jim Lange: Sorry about that!
Mike Jones: No, no, I think that’s good because it gives other people a sense of what you think might be a material amount that would justify the cost.
Jim Lange: Yeah, and the other thing is, sometimes we give the trustee the right to, in effect, distribute the entire trust and just be done with it.
Mike Jones: Yeah, some states’ laws have the ability to terminate trusts that are not economic, and we certainly have that in California. I suspect you have that out there as well.
Jim Lange: Yeah, because again, you know, and you’ve probably seen this in your practice, where some attorney has drafted a trust, and often, the trust wasn’t even necessary, and then you’re sitting there as the CPA and you have to charge somebody to prepare the 1041 and to do the K-1, and now the beneficiary (who might be a minor) is now getting this K-1. They may have to file a return, and that return isn’t simple anymore because it’s a K-1. So, you don’t want to necessarily use a sledgehammer when maybe a flyswatter will do.
Mike Jones: Probably true. For the most significant amounts, I’d like to reinforce where it could be valuable also, is when your surviving spouse becomes the surviving spouse, it’s not too uncommon for the surviving spouse to eventually hook up with someone else. I don’t mean that in any disrespectful way. It’s just human nature. Although, in my experience, we guys are more inclined to do that more often than the women are, but what happens is that all of a sudden, the next person winds up with quite a bit of the funds, and that’s another reason to sometimes set up a trust because the surviving spouses are all well-meaning, but, in the end, human.
Jim Lange: I’ll tell you how I have handled that, and by the way, feel free to disagree with me because I’ve actually had this discussion with some other people. I still tend to name the surviving spouse, and sometimes, we even have a contract that says…and this is more often for second marriages, but it can be for a first, where the contract says that the surviving spouse must name the children as the beneficiary of the IRA, and the reason I’m not a great fan of putting money that is meant for the surviving spouse in a trust is because of the things that we are talking about, in terms of accelerating income taxes. I don’t know if that’s fair or not.
Mike Jones: I would reinforce that and say that, in principle, I agree, and in fact I have worked fairly hard for some clients to get the surviving spouse a rollover when the trust or the estate was the beneficiary, and it’s a rather expensive proposition because the IRS hasn’t told us we can do it. They make us go get a private letter ruling, which is quite expensive and time-consuming.
Jim Lange: Yeah, Bob Keebler does a nice job, if you…do you do that yourself? I just refer that to Bob.
Mike Jones: Yeah, Bob and I have both done those. I just got a couple of those in last week.
Jim Lange: All right. Well, why don’t we go backwards for a minute, if we could, and talk about an inherited IRA? Because, early on, you said how important it was that you wanted the IRA to be treated as an inherited IRA. So, we’re done with the spouse now, and now we’re talking about money going to, let’s say, children or grandchildren, or anybody other than a spouse. What is an inherited IRA, and is there a difference between an inherited IRA and a stretch IRA?
Mike Jones: So, an inherited IRA is just the destination for an IRA of a decedent. It’s set up as an IRA, and it usually says somewhere on the title that it’s a decedent’s IRA, or an inherited IRA, or a beneficiary IRA. All three terms are synonymous. And once that account is set up, the really, really important thing to remember is that in order to move money from the IRA that was in effect when the decedent was still living into that inherited IRA, it has to go directly from the account that was there during the lifetime to the account that’s set up after death. It has to be a direct transfer. If you’re not the surviving spouse, you may not make a tax-free rollover. So, if you wind up with the money coming out to you personally, it is game over and you’re going to pay income taxes on the entire sum today. So, that gets us to the question of the stretch IRA. The inherited IRA, in most cases, is going to allow you to stretch IRA distributions over the life expectancy of a beneficiary. So, instead of having to take all the money out within five years after death, for example, and paying all the income tax on it when it comes out, you can drip it out slowly and pay the taxes slowly, and it’s beneficial from a financial standpoint to make Uncle Sam wait for the money. Like every good financial officer (and every corporation knows the chief financial officer), if you ask him, “When would you like to pay your bills?” The answer is, “Later.” And the same applies to the tax bill on your inherited IRA.
Jim Lange: Yeah, and by the way, that’s kind of one of the whole bases for this whole conversation, and maybe just to go through a quick example, let’s say that you die with a million dollar IRA, and let’s take the extreme, and you leave it to a grandchild who is taking a minimum required distribution of the IRA. Maybe we’ll talk about that. So, maybe he’s taking out starting with one or two percent and letting the money continue to grow income tax-deferred. Then, the next year, he takes out a little bit more, but again, it’s still less than the IRA’s earning, and you get this great, what we’ll call, stretch IRA or ability to defer the taxes. But if the paperwork is done wrong, and it could be something as simple as the IRA not being titled correctly, so instead of the name of the decedent, like you had mentioned, ‘for the benefit of grandchild’ or ‘child,’ if somebody botched it and just put the name of the child, or the name of the grandchild, then you don’t have a successful inherited IRA. That beneficiary then would have to pay income taxes on the whole thing. So, let’s say, you had to pay tax on a million dollars, and now the tax is maybe $300,000 or $400,000, and now, the amount left is, let’s say, $600,000 or $700,000, but now, you have to pay tax every year on the earnings and dividends of that $600,000 or $700,000. So, it really becomes an income tax disaster instead of a wonderful income tax planning tool. So, that’s why this stuff is just so important. I can’t even begin to say how important your book is, which, by the way, I will mention again. The name of the book is Inheriting an IRA: How to Create a Lifetime of Paychecks, and again, that’s by Mike Jones, and you can either get that at Amazon, and if you don’t have a good memory, like me, with some of these things, particularly if you’re in your car, all you have to remember is ‘Jones,’ and then go to Amazon, type in ‘inheriting an IRA,’ or even just ‘IRA inheritance,’ and then ‘Jones,’ and it’ll get to it, or inheritinganira.com.
David Bear: You know, this probably is a good time, since we’re doing a commercial, let’s do a commercial for the Lange Money Group.
David Bear: And welcome back to The Lange Money Hour, with Mike Jones and Jim Lange.
Jim Lange: Hi. We were talking about Mike’s book, which is Inheriting an IRA: How to Create a Lifetime of Paychecks, which I, again, highly recommend, and you can get that at Amazon. Just remember ‘inheriting IRA’ and ‘Jones,’ or inheritinganira.com. And I know that the book is also geared towards people who inherit an IRA, but if we could talk about what Natalie Choate calls ‘the planning mode.’ And instead of cleanup mode, planning mode meaning we’re going to try to do this right. Cleanup mode being, okay, somebody’s died. We didn’t get it exactly right. What should we do? But let’s go into planning mode. Mike, do you ever see attorneys actually plan for a potential series of disclaimers? And maybe you could tell our audience what a disclaimer is, and see if you have found value in disclaimer planning?
Mike Jones: Sure, I’d like to do that. Before we do, Jim, may I just make one comment about what we were talking about just before the break?
Jim Lange: Certainly.
Mike Jones: So, you talked about the inheriting of the inherited IRA somehow getting botched, to use a kind word, and one thing that occurred to me while you were saying that is well, what could someone who is inheriting an IRA do to reduce the possibility that that will happen? And that is, when you set up the inherited IRA, make sure that the paperwork says that you’re setting up an inherited IRA and not setting up your own IRA. There could be boxes to check that say that. You want to make sure you understand those forms, and when it comes to understanding those forms, they can be complicated. So, you want someone looking over your shoulder when you’re handling that transaction.
Jim Lange: Well, that could easily be the difference between, literally (as your subtitle says), a lifetime of paychecks, or a massive tax bill. I think you’re being a little generous because you’re trying to save some people money. That is not something I would recommend somebody do on their own, and you even have to be really careful about which financial advisor…I know, in your book, you have kind of a horror story when there were some pretty good financial planners and attorneys and…actually, I think, in your example, there was a good CPA, a good attorney, but a bad financial advisor, and they had that bad result.
Mike Jones: Yes. So, getting back to disclaimers…
Jim Lange: By the way, thank you for stopping me though, because it is critical, and I would say to get this stretch IRA after you’re gone, it is critical to do the planning right before you die, and then to have your heirs get the right advice after you die, and you need to do it both times correctly in order to get the best result.
Mike Jones: So, what I hear you saying is, is that you want to make sure that your heirs are well-advised just as you are?
Jim Lange: Well, yeah. I actually like to have a meeting with the heirs, you know, while mom and dad are still around, and we’ve had some great, what I’ll call, family meetings that really give people an idea of what is coming. Sometimes the amounts are disclosed. Sometimes they’re not. But if everybody’s on the same page while mom and dad are alive, that’s the best thing. And the other thing is, it’s sometimes kind of a cathartic meeting for dad because he gets to display his values, and the kids can do nothing but sit there and listen. They don’t have a choice.
Mike Jones: It’s all true. The one possible beneficiary we haven’t yet mentioned, Jim, is if my million dollar IRA is taxable and I want a third of it to go to charity, I can say that on my beneficiary form and the charity can just take that out right away without having to worry about taxes at all.
Jim Lange: Well, that’s a great point, and so if people have both a…let’s say you want to leave some money to charity and some money to private heirs (children, grandchildren, nieces and nephews). Rather than leaving money to charity in your will, I would leave the money that you’re going to leave to charity through the beneficiary of the IRA. That way, neither the charity nor your beneficiaries have to pay income tax.
Mike Jones: So, that’s true for a taxable IRA. You might not want to do that with a Roth IRA because those distributions are going to come out tax-free.
Jim Lange: That’s exactly right. So, you would actually never leave…I’ve never left a Roth IRA to charity. You know, I always want to leave that to an heir. And even people who are very charitable, usually they want to leave some money to an heir.
Mike Jones: Also true.
Jim Lange: But anyway, I interrupted you. You were about to talk about disclaimers.
Mike Jones: Sure. So, a disclaimer happens when somebody who is entitled to get property after death says, “I don’t want it.” So, for example, if Jim left me his IRA, and I really appreciate Jim’s appreciation of me, but I noticed that on his beneficiary form that if I die before he does, that it’s going to go to his children. I can disclaim that. I can basically say, “I don’t want to have that.” Likewise, Jim might say on his beneficiary form that his children are going to get the IRA, but each child could make a disclaimer of that child’s share, and if that happens, it might then go on to grandchildren. And so, there is a possibility to set up disclaimer thinking, or disclaimer opportunities, right within the IRA beneficiary form.
Jim Lange: Right, which, by the way, is our standard beneficiary form. We typically, in what we call the “Leave it to Beaver” family (the original husband, the original wife, same kids, same grandchildren), the typical beneficiary form would be leaving everything to the surviving spouse, but specifically saying the surviving spouse has the right to disclaim to, typically, children equally, then each child gets to do whatever they want with their share. They could either keep it in whole, or I include language that they could disclaim, typically into a well-drafted trust for the benefit of their children. And then, so maybe one child might need all the money, one child might disclaim all the money, and one child might keep some of the money and disclaim some of the money, and then we give the surviving spouse that same option. I don’t know if you see a lot of that in practice, or if you see more of, let’s call it, post-mortem planning that Natalie Choate might call ‘cleanup mode?’
Mike Jones: Yeah, I have seen cleanup mode with disclaimers in my practice where someone forgot to add a child to a beneficiary form who was born after the beneficiary form was first made out, and what we did is, that was set up to go to the children, and what we did was we used a series of disclaimers, basically to get the money over to mom, who would then set up an IRA and name all three children equally. And I should mention, the disclaimer concept doesn’t just apply only to IRAs. It applies to anything that someone has given to you through the trust or through a will that you don’t want. So, if Jim were to leave me his pet pig, I could say, “I don’t want that.”
Jim Lange: And then, if I thought about it when I was drafting the will, I would say what would happen if Mike doesn’t want it, and that’s kind of the key of the, what we think is the best estate plan, where you leave it to the surviving spouse, they get to decide what to do with it, and if they disclaim or don’t want it, you say what happens to that disclaimer, which is typically children equally, then you give each child the option. So, we do that a lot in planning mode, and we have found that it works out very well in practice, and we’ve done not quite 2,000 estate plans, and I would say virtually all of the ones with classic “Leave it to Beaver” families (original husband, original wife) have some disclaimer component to that.
Mike Jones: That can work very well. It must be remembered that you have to exercise the disclaimers within nine months of death. So, you don’t have a lot of time to think about it. So, you need to get on top of that fairly quickly.
Jim Lange: Yeah.
David Bear: If I can butt in here, we have one more question that, I think, might be pertinent to this issue, and it’s from Robert, and he says, “I see you’re based in California. This pertains to handling of a Roth IRA started before marriage, and then distributed following a divorce. What happens if somebody in California funds a Roth IRA entirely before marriage, and then no longer funds it during marriage (although, internally, the Roth IRA continues to grow) and the couple gets divorced? Does the entire Roth go back to the person who funded it initially before the marriage, or is the divorced non-funding spouse entitled to some of the growth that occurred during the years they were married, even though no additional money was added from either spouse?” That’s a long question. Did it make sense?
Mike Jones: Yes, it made sense to me, and I’m going to say the thing that wasn’t said in there. California’s a community property state, one of nine. There’s a tenth one in Alaska by election. And in a community property state, everything that I earn belongs half to my wife, and the other half belongs to me. But, on the other hand, if I come into the marriage with property, that’s my separate property, and as long as I maintain proper records, it will still be separate property either upon my death, or if I would unfortunately get divorced, that would still be my separate property there as well. So, in California, earnings on what you have on the property that is your separate property continues to be separate property. In other states, that’s not necessarily so. I believe, but I’m not certain, that in Texas, for example, that earnings on property during marriage is community property. So, you really have to look at the state law of the state that you’re in and make sure that you’re talking to someone who is competent in family law when it comes to maintaining separate property.
Jim Lange: And by the way, this is a good plug for living in California while you are working because California will give you a break on your IRA and retirement plan contributions, but not a good state to retire in because they will tax your IRA distributions. So, I have a client and friend who spent his career in Pennsylvania where he didn’t get a break when he put money into his 403(b) and 401(k) and IRAs, and then he moved to California, and now he has to pay income taxes when he’s taking distributions. So, sometimes, the different laws of the different states do have a significant role. And so, what I wanted him to do, and actually, he did (I love when clients listen to me), is he made his Roth IRA conversion in Pennsylvania when it wasn’t taxable, and then he went to California, and then when he took distributions from the Roth, that wasn’t taxable either.
Mike Jones: Interesting strategy if you happen to be in motion.
Jim Lange: Yeah. All right, so, the other thing that we were, let’s say, talking about, was we love the idea of stretching this IRA, but sometimes…and we’ve had a little discussion of charities and children and grandchildren, but we haven’t really talked about…and we talked about trusts a little bit, but what happens if…and let’s forget about the standard situation when we have young grandchildren, but what if our beneficiary is a spendthrift? What if, you know, we have a son or a daughter who, you know, they would buy a guitar before they would pay rent? Or what if we have, what I would call, the no-good son-in-law, or the no-good daughter-in-law, or we have some creditors around. What would be your advice to somebody who would typically, if it weren’t for tax reasons, and let’s assume that there was a significant IRA involved, so the cost of the trust would not be a big factor, either in terms of preparation or administration afterwards, leave their IRA to a trust? Would you still be okay with leaving an IRA to a trust?
Mike Jones: Well, you brought up a situation where it’s not unlikely that the intended beneficiary is a spendthrift, and so that sort of person can do one or two things. They can either spend the money long before you intended them to and kind of blow through it, and I have to say that as a guitar player, I take exception to your example!
Jim Lange: Uh-oh!
Mike Jones: But having said that…
Jim Lange: But you’re also a conservative CPA. You’re going to pay your rent or your mortgage before you go out and buy your tenth guitar, but maybe not!
David Bear: Didn’t I see something about paddle boarding too?
Mike Jones: The paddle boards are getting to be pretty expensive too. So, if you go beyond those means and you get yourself in real hot water, the money could be sitting in a stretch IRA, and it may be possible for a creditor to get to it. There was a case that came down this last year on the U.S. Supreme Court called Clark vs. Rameker, and, in that case, the Supreme Court decided that an inherited IRA is part of the bankruptcy estate that creditors can get to. And so, that means that if you think that you may have a spendthrift problem with an intended beneficiary, a trust may be a very desirable way to go, not only to make sure that stretch out occurs, but also to protect that inherited IRA from creditor claims.
Jim Lange: Yeah, we also have a special trust that we’re unfortunately doing more and more of, and we have a name for it. It’s the ‘I don’t want my no good son-in-law to inherit one red cent of my money’ trust, because a lot of clients trust their kids, but they don’t trust their son- or daughter-in-law, and they fear that situation about the question that came up earlier, what if there’s a divorce?
Mike Jones: Well, I look at it this way: if the money doesn’t go where you want it to, it may as well have been a 100% tax.
David Bear: At this point, why don’t we take our second break?
David Bear: And welcome back to The Lange Money Hour, with Mike Jones and Jim Lange.
Jim Lange: And Mike Jones is the author of a terrific book that I’m going to recommend that anybody get. Don’t even think about it. Just get it. And if you don’t find value from it and you got it because I recommended it, I will personally refund your money. Anyway, the book is Inheriting an IRA: How to Create a Lifetime of Paychecks. It’s a very valuable book. It was endorsed by Ed Slott, Bob Keebler, Natalie Choate, and myself, and I would recommend that you get it. On the subject of getting books, earlier this year, we had Jonathan Clements, who just wrote a fabulous book. Maybe it’s Jonathan Clements on Money, or something like that. It’s at Amazon. What you could do is go to Amazon, if you’re in your car, just go to Amazon, do “inheriting an IRA”, type in “Jones”, order that, then order Jonathan Clements’ book also, and I give the same guarantee. That’s just a great book, and he’s a great writer. But anyway, Mike, one of the things that we have been talking about is this great, wonderful stretch IRA, and that is the law today. But there’s some rumblings in Congress, and some pretty serious rumblings, that this stretch IRA might not exist in the future. Do you fear a change in the tax law?
Mike Jones: Yes, I do. It has shown up in the last two measures while they were still in the legislative debate stage that had to do with funding our highway system, and, in both cases, it thankfully got removed before the law was passed. So, you know, the stretch IRA could be defeated by Congress at any time. I’m not quite sure what will happen with the Republican Congress, given that there may be a propensity of the current president to veto most of what Congress is going to pass in terms of tax reform. We’ll just have to wait and see how that happens. But with that said, I think the first folks who would be in line to object to that are the ones who paid dearly to make Roth IRA conversions, because they did so on the premise that they were going to do the conversion, and then, someday, leave the money, say, to the grandkids and get stretch and Roth IRAs. And, to me, it would be a very unfortunate case of bait and switch for Congress to give them the incentive to do the Roth IRA conversions, and then turn right around and slam the door shut on stretch distributions after that.
Jim Lange: Well, I think it would not be fair. On the other hand, I really fear it is coming. There was a vote in 2013. It was 51-49. At the time, actually, the House was happy to kill the stretch, and it was the Senate that didn’t. President Obama does want to kill the stretch, and as I understand it, there’s a Republican House that wants to lower tax rates, but they will do so by eliminating the stretch. So, I think that it is very possible, and because we like to be a little bit proactive about what could happen, what are some of the things that you could think of that somebody who is, say, fearful of the stretch not being an option anymore, should be thinking about, and is there some planning that we can be doing in terms of if we think the death of the stretch is coming or if we think there’s a very good chance the death of the stretch is coming? Is there anything that we can think about doing now?
Mike Jones: Yeah, there are a few things. Number one, take very good care of yourself. Number two, if you trust your spouse, leave it to your spouse, because the spouse will be the one exception to the five-year rule, and the spouse will be able to take that rollover, or take distributions over her life expectancy, even in the face if the law changed the way that I’ve seen it drafted in the past. Some other possibilities beyond that, one thing that I have been thinking about is a trust which is called a charitable remainder trust. It’s a little complicated, but it comes down to this: you’re going to give a little something to charity when your children have died, and in the meantime, they get something very, very much like the stretch. And economically, it’s way better than the five year rule, but not quite as good as stretch distributions.
Jim Lange: It’s really interesting to me that you said that because…by the way, we sometimes have attorneys on who, let’s say, get the legal part, but not the CPAs who crunch the numbers, because we’ve crunched the numbers, and that is one of our proposed solutions, which is naming a charitable trust as the beneficiary of a retirement plan, and then, what would happen is the beneficiary, which would typically be your children, would then be able to slow down, or get something not quite akin to the stretch IRA, but the same idea of deferring income taxes. And you’re right. At the end, the charity does get some money. But when we have run the numbers, even if you don’t care about charity, even if you hate charity and all you care about is your kids, we are finding that that is more desirable. And again, you have to take into consideration administrative costs, so I’m not going to do this for $50,000 or $100,000 or less, but for a couple hundred thousand dollars, we’re finding that the kids are actually better off than if you leave it to them directly if this law passes. On the other hand, I wouldn’t draft that trust and put it in effect right now until the law actually did pass because that trust is not as favorable as just leaving it to the children outright under today’s law.
Mike Jones: Agreed. You’re basically, again, leaving charity something at the tail end of the time when your children have survived. In other words, when your kids finally die off, that’s when charity gets something, and by then, it’s not as valuable as what they’re going to get. And so, on balance, you are best off making friends with a charity, and if you wanted to, you could give the children a little bit of control over who ultimately benefits on the charitable side by leaving that to a donor-advised fund where the children are able to say which charity gets to have that when they die.
Jim Lange: Well, I think that that’s a very good idea for a couple reasons. And I believe this, not just in this context, but in other contexts. I think it is great to teach children, even from a young age, the value of putting away something for charity, and getting children involved in charities, both in terms of financial contributions, and then also volunteering actual personal labor contributions. The other thing that we have been looking at (and I don’t know if you’ve run any numbers on this), but actually, in a private correspondence, Ed Slott said that if this law does take effect, that people will be really compelled to be doing something that they should have been doing all along, which is actually buying life insurance. And we’ve run some numbers that compare life insurance under the existing law, which it’s still favorable, but not nearly as favorable as compared to life insurance with the death of the stretch IRA. I don’t know if you’ve looked at any of those numbers or not?
Mike Jones: Well, that can be beneficial. Another thing that could be beneficial is to go into an annuity. A lot of people do not realize that annuities can actually pay over the life expectancy of a beneficiary. In fact, a lot of advisors forget that. And when I have looked at the contracts, they almost uniformly put that in there because the tax code allows it. You just have to start taking those distributions by the end of the year after death.
David Bear: Gentlemen, we’re getting close here to the end of the show, so I’m going to have to break in. Any last words here?
Jim Lange: Mike, why don’t you tell us what’s next for Mike Jones?
Mike Jones: Sure. Trustees are going to get the IRAs. As we discussed, my next book is going to be for the trustees about how to administer inherited IRAs that go to trusts.
Jim Lange: All right. Again, the book is Inheriting an IRA: How to Create a Lifetime of Paychecks by Mike Jones. Just go to Amazon, search for “inheriting an IRA – Jones,” and you should find it.
James Lange, CPA
Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania. He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again. He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans. His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans. Jim’s advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger’s Retirement Reports and The Tax Adviser (AICPA). Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.