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The Ideal Beneficiary of the IRA
James Lange, CPA/Attorney & Nicole DeMartino
|Click to hear MP3 of this show|
- Update on Pending Legislation for Roth Designated Account Conversions
- Minimum Required Distributions for IRAs
- Two Basic Types of Beneficiaries
- Estate Tax Exemptions
- Cruelest Trap in Estate Planning
- Lange’s Cascading Beneficiary Plan
Nicole: Hello, and welcome to the Lange Money Hour, Where Smart Money Talks. This is Nicole DeMartino and, as always, I’m here with your host, Jim Lange. Jim is a CPA and the nationally recognized Roth IRA expert and best-selling author of the first and second edition of “Retire Secure!” Actually, he’s just about to bring out his third book, “The Roth Revolution: Pay Taxes Once and Never Again,” and if you want a sneak peek at Jim’s book, we’re anticipating this will be out in the fall, but you can take a quick look at it if you jump on our website at www.retiresecure.com, you sign up under Roth Revolution and, if you do that, I’m going to send you back a free chapter. It’s a very compelling chapter and the table of contents. That gives you a sneak peek before the entire book is published. So, we have a really jam-packed show today, and we’re going to be covering everything estate planning, so Jim, do you want to get to it?
Jim: Okay, let’s do it.
Nicole: Alright, we’re talking about estate planning today, but first, if our listeners out there, if you remember the last show we had done, we talked about proposed legislation. It’s in Congress right now. We wanted to give you an update on what has happened since our last show, and if you remember, this is proposed legislation that will allow a person to take money from their 401(k) or their 403(b), take money from it, a portion of it, and convert it to a Roth designated account while they are still working, and the reason why this is so exciting is this allows people to do the conversion much earlier, and you can start the tax-free growth, it even has a longer time to cook than if you do this after you’re done working. So, Jim, where do we stand?
Jim: Well, right now, I was actually hoping that is was going to be passed either the day of the show or the following day, and that did not happen. It looks now like it will pass in September. I think the overriding feeling is that this is a winner, that this will pass, but it is not tax law yet. I think it’s very good to prepare and be ready, so when it does pass, that you will know what to do.
Nicole: Okay, good. We’ll keep you up to date on that, and as things progress, we do if you do come to our website, www.retiresecure.com, if you sign up, you’ll then be on our e-mail list, and if something should happen in the meantime between shows, we’ll certainly get that out to that list. You can also always call our office too for the most current information. Alright, Jim, we’re going to be talking about estate planning and let’s get to it. We’re going to cover all the bases. I want to start talking about the minimum required distributions, MRDs, and these are the distributions that people take from their retirement plan when they turn seventy-and-a-half. They have to do that. So, give me a summary on those rules for IRAs that someone has to abide by.
Jim: Alright, I will do that, and I’ll tell you why I think that you’re starting at the right place, because when you’re talking about estate planning for IRA owners and Roth IRA owners, there’s really two taxes involved that you have to take into account. One tax that historically been the one to get the most attention was the estate, or for Pennsylvania residents, the PA inheritance tax, for other state residents, whatever inheritance tax your state has, so we have, let’s call that the transfer taxes, but then we also have the income taxes to worry about, and for IRA owners and for Roth IRA owners, it’s the income tax implications of estate planning that might be even more important. Now, what I’m eventually leading up to is explaining the income tax working, or how it works for income taxes if you die with an IRA or a Roth IRA. But before I even do that, I want to get into what happens just a plain old IRA owner who is retired and he turns seventy. So, why don’t we do that first, then we’ll do what happens when that person dies, and then we’ll cover it for both IRA owners and Roth owners.
Nicole: Sounds great.
Jim: Okay, well first, let’s assume a traditional IRA, and let’s assume that somebody is retired, and whether the amount isn’t important for our purposes here, but what will happen is that at age seventy-and-a-half, and technically, April 1st following the year the IRA owner turns seventy-and-a-half, he or she will have to take a minimum required distribution whether they like it or not. In other words, all this money that either you and/or your employer contributed throughout your career, and then the money grew tax-deferred, that is, you didn’t have to pay taxes while the money was growing, or maybe in the last couple of years shrinking, but you didn’t have to pay taxes. But eventually, you or perhaps your wife or your children or your grandchildren will have to pay taxes on all that money and the accumulation. Well, the IRS says, “Okay, when you’ve turned seventy-and-a-half, you’re going to have to start taking minimum required distributions.” Now, maybe you just need that money to meet your monthly living expenses. Let’s say, you don’t need that money. You have other sources of income, you have after-tax dollars, and I usually prefer spending after-tax dollars before IRA dollars, or let’s say that you have something else, like Social Security or a pension or whatever, it is usually not to your advantage to take a large distribution from your IRA, because you’re going to have to pay income taxes on it. But you must take out a certain amount, and that’s called the minimum required distribution, and the way that is calculated is that you take your life expectancy, and then, under a relatively new law, actually not so new, it goes back to 2001, you would then add ten years. So let’s say, for discussion’s sake, that you’re seventy years old, and that your life expectancy, according to the IRS tables that can be found in publication 590, is roughly sixteen years, then you would add ten to that and you would get roughly twenty-six, or really, what it comes down to is roughly 4% of the balance of your IRA must be taken out the year after you turn seventy-and-a-half, April 1st the year after you turn seventy-and-a-half. That pattern of taking a minimum required distribution with your life expectancy plus 10 as the divisor will continue as time goes on, meaning that as you age, your life expectancy will go down and you’ll have to take out a higher and higher minimum required distribution. Now, if you’re starting at roughly 4%, if your investment is doing better than 4%, then your IRA is actually growing, at least in the early part of your retirement, and that might turn around and say, when you’re in your mid-eighties, depending on your investment rate and your returns. So, those are the basic rules for a minimum required distribution while you’re alive.
Nicole: Alrighty. Let’s talk about, do you want to talk about the rules after you pass away then?
Jim: Alright, and let’s separate the rules into two basic types of beneficiaries. One is the spouse, and by the way, I want to keep things relatively simple. There’s actually a few more options, but I’m going to keep it simple and what is usually the best way to do it, which is for the spouse to do a spousal rollover, or a trustee to trustee transfer. So, your IRA then goes to your spouse. Now let’s say, for discussion’s sake, that you were past seventy when you died, and you were taking a minimum required distribution and the money now goes to your spouse, and let’s say your spouse is the exact same age. Then your spouse will have to take minimum required distributions, and it’ll basically be at the same schedule that you were. If your spouse is a little bit younger than you, but let’s say, is still past seventy, then your spouse will have minimum required distributions but they’ll be a little less than you because she has a longer life expectancy according to the tables. If your spouse is not yet seventy, then he or she will not have a minimum required distribution, and they can wait until they’re seventy before they have to take a minimum required distribution. So, it really kind of continues the same pattern, but we’re going to base the life expectancy, which is the divisor, the number that you divide into the balance of the IRA as of December 31st of the previous year, to determine the minimum required distribution for the spouse. And again, assuming that there is other money to spend, we usually want to take the minimum required distribution. Alright, now, what happens if we have a non-spousal beneficiary, typically children, maybe a grandchild, maybe a niece or a nephew, or maybe a partner? Anybody who is not a spouse. What will happen then is the non-spouse beneficiary receives a different type of asset. It is a unique beast. It is not an IRA, and in addition, the income taxes that have not yet been paid on it are not accelerated. Assuming the paperwork is handled correctly, which by the way, is a very important assumption and it often isn’t, but let’s assume that it is, that what will happen is that non-spouse beneficiary will have a unique asset called an inherited IRA, alright? And this inherited IRA, they must take minimum required distributions of this inherited IRA, even though they are not yet seventy. So, let’s say, for discussion’s sake, that it is a child who is the beneficiary, and let’s say the child has a thirty-year life expectancy. Then the child would take a minimum required distribution of thirty divided into the balance of the account, or roughly 3% of the balance in the inherited IRA. Then, the next year, their life expectancy, according to the tables, would go down by one year and they would take 29 into the balance. The next year, 28, next year, 27, etc. The difference between an inherited IRA and an inherited Roth IRA is you have the same factors that you must take a minimum required distribution of the inherited Roth IRA just like the inherited IRA, based on the same factors. The difference is, the inherited IRA is a taxable distribution, and the inherited Roth IRA is non-taxable. Now before, when the husband and wife were alive, there was no minimum required distribution on a Roth IRA, and even after the first spouse dies, there’s no minimum required distribution on a Roth IRA for the spouse, but there is a minimum required distribution for a non-spouse. Now, let’s say, for discussion’s sake, that there’s two possible generations you could leave your IRA to. One is, let’s say, your children, and two, your grandchildren, or better yet, a well-drafted trust for the benefit of your grandchildren. What would happen is, your child would have a much higher minimum required distribution, and the other thing is, let’s say, after 25 years, the minimum required distribution would be very high. So, even though we are getting what is commonly known as a stretch IRA, it will not be as long of a stretch IRA if we have a younger beneficiary. So, sometimes, we might want to name a younger beneficiary, so let’s say a grandchild, who might be ten or twenty, will have a much longer life expectancy, will have a lower minimum required distribution of the inherited IRA or Roth IRA, and then what will happen is that beneficiary will get many, many years of tax-deferred growth, or in the case of a Roth IRA, many years of tax-free inherited Roth IRA conversion distributions.
Nicole: Alright, Jim, we’re going to take a short break, and when we come back, we’re going to actually go into the estate tax taxation. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole: Welcome back. You’re listening to the Lange Money Hour, Where Smart Money Talks, and I’m here with Jim Lange. We’re talking about estate planning today, and we’re going to go into the topic of estate tax taxation now, and, Jim, could you give me a description of some estate tax exemptions?
Jim: Yeah. We’re now switching from the income tax area, which is what we were talking about on the first part of the show, to the transfer tax area. This is a tax on transferring wealth from one person to another. In law school, they used to talk about the fruit in the trees, and the fruit was the income tax, or the income, and the ownership of the tree, that was the estate, or transfer, tax, and there’s a couple of things that you have to keep in mind. First, you have to keep in mind the federal estate tax, and then we’ll talk mainly about the Pennsylvania inheritance tax, but I know we have a national audience, so it could actually be any state that you happen to live in. But, let’s talk about the transfer tax. Now, as you know, 2010 is this incredible year of flux and people not knowing exactly what to do because, as of this year, there is no federal estate tax. So, when George Steinbrenner just died and his interest in the Yankees, by itself, was $1.5 billion, and you would normally expect, you know, estate taxes of around $500,000,000 or somewhere in that area, and unless they make a retroactive change to the estate tax, it looks like his family will be able to get that without any federal transfer taxes at all. So, this is actually, unless they make a change, now, that’s important because there’s a lot of discussion that they very well make a retroactive estate tax change, and they might make the exemption $3.5 or $4 million, but the longer the year goes, I think the harder it is, and it’s unclear what’s going to happen. Now, next year, the exemption is going to be $1 million, unless there’s a change, which we think there is. We think it’s going to go to something like $3.5 or $4 million. On the other hand, if you’d asked me last year, I would’ve never thought that they were going to go up until unlimited this year.
Nicole: Let me ask you this: so if you’re in that position, because it could go retroactively, correct?
Jim: Sure, it could.
Nicole: It could. You’d better put some money aside, right, until it’s settled?
Jim: Well, I’m a great believer in flexibility.
Jim: And I think that what you should do is, and we’ll talk about this more as the hour goes on, but I think that the rational response to this extreme flux in the estate taxation rules, and by the way, we also have flux in the income tax rules. The Bush tax era tax cuts are scheduled to sunset next year, but there’s a lot of talk saying that they won’t, so we don’t know what’s going to happen with the estate tax. We don’t know what’s going to happen with the income tax. So that, to me, is our starting point is that we just don’t know what’s going to happen, and I think anybody that tells you what is going to happen, like if you’d listened to me last year, I was wrong! That was my best guess, but I think that probably the best strategy is to say, “Geez, we don’t know what’s going to happen.” Rather than doing a plan that absolutely counts on one law or another, is there a possibility to do a plan that might be flexible no matter what the law is?
Nicole: Sure, that would be the way to go.
Jim: Alright. Now, in terms of the exemption amount, that’s the amount that you’re allowed to die with before your estate pays any federal estate tax. So historically, for example, that number was $600,000. For years and years and years, if you died with less than $600,000, there was no federal estate tax. If you died with more than $600,000, there was a federal estate tax unless, and this is after 2001, you left the money to your spouse. If your spouse is a U.S. citizen, there is an unlimited marital deduction, meaning that your spouse doesn’t have to pay any federal estate tax, and that, by the way, also applies to Pennsylvania residents. You can thank Governor Ridge for that. There is no spousal tax on money that is left to a spouse, assuming again that the spouse is a U.S. citizen, at either the federal level or the Pennsylvania level. So that was one good thing, and then, the number was $600,000. Last year, in 2009, it was $3.5 million. This year, we think it’s unlimited, but we don’t know. Next year, it’s scheduled to be a million dollars. Most people that you would ask who are knowledgeable in the area assume that it’s going to be changed, and it’s going to come in somewhere between $3.5 million to maybe $5 million, but we just kind of don’t know what that is. But that is called the federal exemption amount, the exclusion amount, the unified credit shelter amount, and that amount is the amount of money that you’re allowed to pass at death before there’s any federal estate or transfer tax.
Nicole: It amazes me that something that important hasn’t been decided on yet. It’s amazing.
Jim: Well, I actually think it’s pretty incompetent, and no matter which side of the aisle you sit on, or your swayed towards, I think that you just have to say that this is just ridiculous that there’s no plan, that there’s no scheme, and that there’s no order. You know, I forget the guy who said it, but somebody said that the federal laws ought to look like they were devised on purpose instead of this kind of random mess that we have.
Nicole. Right. Well, the next thing, I’ve heard you talk about this at the workshops, and I’ve heard you talking about it in the office, and you’ve coined it the cruelest trap of all. What is the cruelest trap of all in estate planning?
Jim: Well, let’s assume that you have had your wills done by an attorney, which we would certainly recommend, and the attorney, by their nature, are very worried about you paying federal estate tax, and since probably 1066, or even before that, attorneys have tried to devise ways to avoid paying federal transfer tax. In fact, back in England, they didn’t even have an income tax. It was all transfer tax or death tax. They’ve been trying to avoid ways of paying federal estate tax. Now, one of the problems even with this unlimited marital deduction, where you could leave as much as you want. You could leave a billion dollars to your husband or to your wife. The problem with that was not the tax at the first death, but at the tax at the second death. So, let’s even just use a $5,000,000 number, and let’s just assume that the exemption goes back to $3.5 million, and let’s forget about growth. So, you have $5,000,000, you die and you leave everything to your husband or wife. Now they have $5,000,000. Then, they die, and let’s say, the exemption is $3.5 million at the time. So, what would happen is the $3.5 million would be exempt, but the excess, or the amount over that, would be subject to federal estate taxes, and back when the exemption was $600,000, there was an even bigger chance of having a federal estate tax. What a lot of attorneys did is they drafted these wills that had provisions called, and again, it goes by different names, the B trust, the unified credit shelter trust, the exemption trust, and basically, what it said was is to take a chunk of money, and rather than leaving it to the surviving spouse outright, you would leave it into a trust, and here are the terms of the trust, and it might sound familiar, and if you think that you have it in your documents, you might deservedly have a shiver run right down your spine, because there’s some problems coming. And here’s what that trust says. By the way, you can’t read it when you look at your will because it’s written in language that you can’t understand. But, the essence of it is that your surviving spouse can get income. They can get the right to invade principle for health maintenance and support. Sometimes, they have what’s called a five and five, which is they can have a withdrawal right of 5% or $5,000 for out of the principle, and then, at the second death, and typically, it would go to the children equally. So, what would happen, let’s say, when the exemption was $600,000, and let’s say there was a $1.2 million estate. What would happen is you would have, let’s say, $600,000 go into this trust, $600,000 go to the spouse outright. At the second death, the money in the trust was not subject to federal estate tax. So, what happened was you were able to pass the entire $1.2 million to the kids without any federal estate tax, or even when the exemption went up to $3.5 million, you could use the same strategy to pass up to $7 million. The problem is the way these trusts are drafted. It doesn’t say how much goes into it. It’s a formula, and what the formula really means is you take the exemption amount, whatever that amount is, and the year that you die, and that’s how much money goes into the trust. Now, if you have that type of document, and there’s hundreds of thousands, probably millions of people who have those types of documents, and they don’t have $7 million. Some of them don’t even have $2 million, and what that document, in effect, says is take the federal exemption amount, which this year is unlimited, and next year, even if it goes to $3.5 million, basically all that money is going to go into the trust, leaving the surviving spouse with nothing. And that is a terrible, terrible result, because the surviving spouse is restricted. Yes, they can get access for health maintenance and support, but what if they want more? What if they want to go to Aruba? What if they want to help their grandchildren with their education? What if they want a second home in a different area? And it is happening quite a bit, and it’s really unfortunate because when both spouses were alive, they each had unlimited control of all the marital resources. Now, with this type of trust that’s so common, and with the portfolios down and the exemption amounts that we think are going to go up, we’re going to find a lot of people that are going to be stuck in these trusts when the purpose was to save federal estate tax, which isn’t a problem, but that doesn’t mean that the trust won’t trigger. And that is the cruelest trap of all, is when you have this type of trust, and you end up restricting the use of the money for the surviving spouse.
Nicole: And I bet that at that time, it’s quite a surprise.
Jim: It is a surprise. In fact, I would say a lot of people don’t even know that they have that in their documents now.
Jim: They say, “Oh, well, everything goes to my husband, or everything goes to my wife, right?” And then, I read the documents, and I say “No, you have this trust.” And they look at me, you know, in shock, and if there’s a bunch of language in your will or irrevocable trust to the nature of the amount is the maximum amount, taking into consideration the unlimited marital blah-blah-blah, if there’s a bunch of completely un-understandable language in your will, there’s a good chance that you have that in your documents, and it’s probably fantastically inappropriate.
Nicole: Okay. Well, when we come back, now that we know what to look for, when we come back, Jim is going to talk about his solution of flexibility, and we’ll be right back. And actually, because the information on this show is so valuable, just as a reminder, you can get all of our shows. The audio files of all of our shows, all of our radio shows with all of our experts, at www.retiresecure.com. If you go on our homepage, click listen now, you can download all of those shows, so you can read them and definitely study them. We’ll be right back. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole: Welcome back to the Lange Money Hour. This is Nicole DeMartino, and I’m here, as always, with Jim Lange. We’re talking estate planning today. Alright Jim, let’s get back into it. We were talking about the cruelest trap of all, and that sounds like a will without any flexibility.
Jim: Well, that is the traditional estate plan, and in the defense of the attorneys who drafted that, that’s what is kind of the standard. So, I would say that most people who had estates of, even, approaching $600,000, that was more or less what estate attorneys did back then.
Nicole: Sure, absolutely. Well, you know, and I would actually encourage our listeners that if you are going on later to look at your will, and the language, as Jim said, it’s not clear, certainly feel free to come to one of our workshops and take Jim up on the offer to consult with him, and you can review that document and make sure it’s in your best interests. Well, what I want to go to now, Jim, and we talk a lot about this, it’s very famous, we hear about it all the time, is Lange’s Cascading Beneficiary plan. This is a plan that Jim had written himself, and tell me a little bit about how this came about, the history of Lange’s Cascading Beneficiary plan?
Jim: Well, when I first started practicing estate law about 25 years ago, I was never a fan of these B trusts or these traditional plans. I actually preferred a much more flexible type of a plan, and frankly, with pretty little support, because I was one of the few people doing it, I developed a plan which we’ll describe a little bit more in detail, but I had written an article in 1998 for The Tax Advisor, which is kind of a snooty, peer-reviewed journal that goes to 60,000 members of the Tax Division of the American Institute of Certified Public Accountants, and even though the article was really centered around Roth IRA conversions, it actually won “Article of the Year” and the main topic was Roth IRA conversions, that’s when Roth IRA conversions first came out, I thought, “I’m just going to slip in what I like to do with a description of my favorite estate plan, and I’ll see what the peer reviewers think about it.”
Nicole: And what did they say? What did they think about it? Because I know they’re a tough crowd!
Jim: Well, they really liked it, and they allowed the publication, and frankly though, not a lot happened in terms of national exposure. It was just one of those things that was out there. I, by the way, in my practice, continued to use it. So, without a tremendous amount of peer support, I just knew in my heart that it was the right thing. Of course, I explained to the clients that it’s always the client’s choice, but I often encouraged it. So then, life goes on, and in 2001, there was an important new tax law, and the tax law actually had to do with the minimum required distributions of the inherited IRAs that we were just talking about. In the old law, let’s say that you left your IRA to your spouse, and your spouse, let’s say, didn’t want it, and the legal word for that is disclaim it. And let’s say that the next beneficiary in line was your child. So you, the 75-year old IRA owner, dies, leaving your IRA to your spouse, who is, let’s say, also 75. Your spouse would have a minimum required distribution based on her life expectancy. Actually, back then, it wasn’t even plus ten, but let’s just say her life expectancy, or if your spouse said “Hey, I disclaim it,” and it went next in line because the spouse can’t say where it goes. All they can do is say I’ll take it, or I won’t take it. If they said I won’t take it, and let’s assume that next in line, or the contingent beneficiary, was your children equally. They would have this inherited IRA, but under the old laws before 2001, they used to have to take a minimum required distribution, not based on their life expectancy, but based on the spouse’s life expectancy. So, what that meant was there was no income tax motivation to disclaim, or say I don’t want it, because if the spouse said I don’t want it and it ended up going to a child or, for that matter, even a grandchild, that young beneficiary would still have to take minimum required distributions based on the older spouse’s life expectancy. So, there wasn’t that much benefit to disclaiming, except maybe getting it out of the estate of the second person to die. Then, in 2001, they simplified it, and they made it much better and they said, “If you disclaim, or if you don’t want it, and it goes to the next person in line, the next person in line” and that’s typically going to be a child, by the way, didn’t have to take minimum required distributions based on the spouse’s life expectancy. They could take it based on their own, which was a tremendous benefit because now they could have a much longer stretch, and if it was disclaimed all the way to a grandchild or a trust for the grandchild, you could maybe have a 70 or 80 year stretch IRA. So this was just such a great law, and it worked perfectly with the type of flexibility that I was doing in my estate plan, because what I was essentially recommending, and this is the essence of the cascading beneficiary plan, is I would name the surviving spouse as the primary beneficiary. I would name the B trust as the second beneficiary, just in case we needed it for estate taxes. I would name the children equally as the third or second contingent beneficiary, and then I would name well-drafted trust for the grandchildren as the fourth, or the third continuing beneficiary. A little nuance there is I would have a separate trust for each set of grandchildren. So now, under the new law in 2001, what you could do is you could disclaim and have your children, or even your grandchildren, get the inherited IRA, get a much bigger stretch or drastically reduced or deferred income taxes, and I just knew the plan that I had been doing for, I guess, around fifteen years at that point was really going to take off, and I had an e-mail list that, at one time, I think we were at about 50,000. But anyway, I wrote an article called “The Ideal Beneficiary of Your IRA,” I sent it out and one of the people that actually responded was Jane Bryant Quinn, and she interviewed me and she wrote it up in Newsweek, and then it was written up in the Wall Street Journal, and then the New York Times, and then I did an article for Financial Planning, and now, if you type in “Cascading Beneficiary Plan” in Google, there’s, you know, probably hundreds, maybe thousands, of entries that somehow point back to me. Now, some of these journals call it the Cascading Beneficiary Plan because they didn’t allow me to use what I wanted to call it, which was Lange’s Cascading Beneficiary Plan.
Nicole: I can see why!
Jim: But, that’s how it really, kind of, took off, and the essence of it, and the real benefit of it, and I think why Jane responded and why all these other folks did, and why it is so popular, is because it creates tremendous flexibility. We have all these uncertainties around us. We don’t even know what the federal estate tax law is today, let alone next year, and it’s really the important year for federal estate tax is the year of the second spouse’s death. So, the truth is, we just don’t know how long we’re going to live. We don’t know who’s going to die first.
Nicole: Right, we don’t.
Jim: We don’t know the size of the estate. We don’t know what the needs of the surviving spouse are. We don’t know the needs of the children, the needs of the grandchildren. There’s so much we don’t know when we’re planning our estates that the traditional, fixed-in-stone, everything going to the B trust plan is really not appropriate, I think, for most people, but there are a couple caveats. We probably have to say who this is for and who it is not.
Nicole: Exactly, and we’re going to take one last break, and when we come back, we are going to talk about who this plan is for, who it’s suited for, and we’ll also talk about some other groups where the plan doesn’t exactly fit and what they can do, as well. You’re listening to the Lange Money Hour, Where Smart Money Talks.
Nicole: Welcome back. You’re listening to the Lange Money Hour, and I’m here with Jim Lange, and we’re talking about his famous Cascading Beneficiary Plan, and we just talked a little bit about the history of how that plan came to be, and how it’s really now the standard of what people need to be using when building an estate plan, but now we want to talk about who this plan has been built for. So, let’s go there.
Jim: Alright, that’s fine. I do have a slight correction. I don’t think this plan is the standard yet. I think it should be!
Nicole: It should be. Okay, I’m sorry about that.
Jim: But I still think that we are in the minority in terms of attorneys drafting this plan, and I think that that is important. Now, the plan got a big boost when I wrote “Retire Secure!,” because I got testimonials from the top guys, Charles Schwab, Larry King, Ed Slott, Bob Keebler, all the top IRA guys, Natalie Choate, and the plan got a big boost then, but I still don’t think it’s fair to say that it is the standard. I think it’s fair to say it’s the best plan, but it is not the most popular or common plan.
Nicole: Alrighty. Thanks for correcting me there, Jim. That’s okay.
Jim: Sorry, I could have let it go, but I didn’t.
Nicole: Be modest! That’s an endearing quality. Okay, let’s talk about who the plan is technically for.
Jim: Alright. See, if you think about the plan, I have the surviving spouse as the primary beneficiary. Now, that’s different than the traditional plan, because the traditional plan has the B trust as the primary beneficiary. So, even if the surviving spouse wants or needs it, he or she doesn’t have a choice. It goes into this trust. My first beneficiary is the surviving spouse. So, it’s really critical that we trust the surviving spouse.
Jim: So, let’s say, for discussion’s sake, that you are not married to the parent of your child. You have a second marriage or a third marriage, and you have your set of kids and they have their set of kids, this plan would not be appropriate for you because if you left everything to your surviving spouse, your surviving spouse, after you die, can change his or her will, cutting out your kids, and leaving everything to their kids. So, this would probably not be a great choice for second marriages where there are children from prior marriages. It would also not be a great choice if you didn’t trust your spouse. Let’s say that your spouse had a much different idea of where the money should go, like, or example, one spouse thinks it should go to the kids, and another one thinks it should go to charity. Well, you don’t want to trust your spouse completely if you’re not on the same wavelength on where the money should eventually go. But, the people who this plan is really ideally suited for, it’s probably a shrinking set of people, but it’s still the majority of my clients, is the group that I call the “Leave it to Beaver” family, which is the original husband, the original wife, and they have the same kids. So, it’s not kids from his marriage or kids from her marriage, it’s kids from our marriage. And let’s even assume, for discussion’s sake, that there are grandchildren here. So, what the Cascading Beneficiary Plan would say is the number one beneficiary is the surviving spouse. If they want it, they keep it, end of story. The second beneficiary is the B trust, so let’s say, the surviving spouse says, “Hey, I’m interested in having the income from that money, but I’m willing to give up the principle, and when I die, it’ll go to the kids.” That’s the second beneficiary. I tend to not use that in the IRA as much. I tend to prefer that for after-tax, or non-IRA dollars. Then, typically, the next beneficiary would be children equally, and that way, each child could get that inherited IRA, and by the way, under the new law in 2001, you can separate the IRA into different accounts after death. Before, you actually had to separate the accounts before death, which was a pain, or else, everybody would have to take minimum required distributions based on the oldest life expectancy, and then the other contingent beneficiary that I like to include in this is well-drafted trusts for the benefit of grandchildren. Now, I want a different trust for each set of children, because if you are a child and you don’t need all the inherited IRA because you can disclaim some because maybe you inherited other money, or you didn’t need all the money, or you’re okay by yourself, you typically don’t want to disclaim to your nieces and nephews. You would rather have that money go to your kids, and you could be the trustee of that. So in the documents I prepare, when I have money going to the grandchildren, it is not necessarily because the child has died. It is because either: a. The child has died, which is pretty unlikely, or b. Much more likely, the child is alive, sees the income tax advantage of having to, again, the legal word is disclaim, or say I don’t want, and by the way, it’s very important that they can say I don’t want a portion. It’s not an all-or-nothing. They can say I disclaim a portion of that money. They want it to go in a well-drafted trust, typically health, maintenance, support, education, post-graduate education, down payment for a home, to their children, not their nieces and nephews. And it is that flexibility for the traditional family unit of husband and wife, children and grandchildren, that this plan is really the most effective, and what it really was designed for and, in practice, works the best.
Nicole: One thing I hear, because, you know, I’m at the workshops with you, and I end up talking to a lot of the people that come, and one of the things that I hear all the time, and we just touched on this, it is so hard now to make these decisions for the future because of the unknown variables that we listed before. So, how does this plan help with the problem of uncertainty?
Jim: Well, remember, it’s kind of a four-part beneficiary form and the surviving spouse gets to choose. Here’s what happens in the real world, because we’ve been doing these now for twenty-five years. Our law firm is twenty-five years old, which is relatively actually young, considering that I started the firm. You know, that is, we haven’t been around for a hundred years, so most of our clients are still kicking. But, we’ve certainly had quite a few deaths, and here’s what happens in the real world. After the funeral, and after, you know, the initial shock of the death, at some point, the surviving spouse will come to my office, typically with one o the adult children. So, let’s say the spouse is in their seventies or eighties or sometimes younger, they will typically come to my office with one of the adult children, sometimes the ultimate executor, and sometimes they remember what we did and sometimes they don’t, but then they’ll say, “Well gee, what is the best course?” And remember, we now have complete flexibility. By the way, sometimes that’s needed. Let’s say the portfolio’s down, the expenses the spouse needs, hey, to heck with the kids, the grandkids and everybody else. They have to wait. The surviving spouse gets it all. Or the surviving spouse might have way more money than they need and they might want each child to get, say, $100,000 or $200,000 while the children are still young and can enjoy that inheritance. Or it might be more appropriate to go to the grandchildren, or the B trust. But what typically happens is the surviving spouse will come in and I’ll explain all the options, and I’m not in a hurry to make that decision. The surviving spouse has nine months from the date of death to make that decision. So, you build in this enormous flexibility, and by the way, that has to be done while everybody’s alive. It has to be set up so that the disclaimer has all of the options. Then, at death, the surviving spouse is going to have all the options. I like to explain all the options. I mean, frankly, a lot of the time, I do know what to do, but I like the surviving spouse to kind of understand all their options and not just mechanically listen to what I think might be best and then also to lean on their adult child for both emotional and technical support. So, it is building that flexibility and letting the surviving spouse have all those options that I think is really the power behind it, and the result of this over the years has been very good. That is, in some cases, the surviving spouse just needed all the money, and that’s what we did. In others, money went to the children. In others, to grandchildren. In some, we had some money going to the child at the first death, and then money going to the grandchildren at the second death. So, that flexibility has worked out very well in practice.
Nicole: Well, it truly makes perfect sense. We have two more minutes to go. Real quickly, Jim, if you don’t mind, in this day and age, there still are a lot of traditional families, but there’s also people who aren’t in a traditional family. Any quick words of advice for that?
Jim: Well, widows and widowers can still use a variation of this where the choices become children and grandchildren. If you have a second marriage with different children, the traditional answer is a Q-Tip trust, and as I said in “Retire Secure!” with beneficiaries of IRAs, I hate Q-Tip trusts as beneficiaries of IRAs. I would probably just recommend a simpler X% to second spouse, and X% to children of the first marriage.
Nicole: Okay. All I can say is come to the workshop, right?
Jim: I think that you will be richly rewarded for coming.
Nicole: Right. Come to the workshop. You’re actually going to see this in a presentation form in front of you. Part of our packet you’re going to get information to take home about this topic. But Jim, thank you very much.
Jim: It’s been a pleasure. Thank you.
Nicole: It always is. Thank you for listening. We’ll see you again here in two weeks. You’ve been listening to the Lange Money Hour, Where Smart Money Talks.
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.