While there is room to disagree about many elements of this year’s proposed tax reforms, one thing all parents and retirees can be thankful for is this: the tax-deferred savings you’ve collected all your life can still be saved for your children. Understanding the rules can give you and your kids extra decades of preferential tax treatment on the retirement plans you leave behind. That extra money can be the difference that lets them retire or even start a second career later in life.
The New Tax Plan
There is plenty of room for disagreement about the new tax plan. A few parts of it are indefensible, such as as elimination of the medical deduction for catastrophic medical expenses: Congress literally decided to pay for a tax cut by taxing cancer victims. But many parts of it stir legitimate (although emotionally charged) differences of opinion: should the government be giving people who make $300,000 per year a child tax credit? Does the mortgage interest deduction encourage people to save by making home ownership easier, or does it give a government subsidy to those wealthy enough to own a home? Is lowering corporate taxes fair because of double taxation? Is it right for the government to penalize people for getting divorced by making alimony (for future divorces) non-deductible?
But one very important set of tax laws are not changing: these are the laws that determine how long you can take advantage of the preferential tax treatment of IRAs, Roth IRAs, 401(k)s, 403(b)’s, and other retirement plans. These plans can still be rolled over into an inherited IRA by your beneficiary, and then the beneficiary will take payments over their entire lifetime rather than yours.
Think about a Roth IRA. A Roth IRA can make money tax free, and payments will be made to the beneficiary over their entire lifetime. Thus leaving money to an uncle will result in much worse tax treatment–and much less money overall–than leaving money to a grandson. The expected lifetime of the beneficiary (or your expected lifetime if it is greater) determines the “applicable distribution period” over which the account will be emptied, forcing a required minimum distribution each year.
Even with a traditional IRA, capital gains within the account are not taxable–only the required distributions are taxable–so the longer you can keep the tax benefit of the account the more money it makes. What’s more, the longer the period for which someone owns the account, the more likely they are to have one or more bad years where they can take some extra income from the IRA at relatively low tax rates.
You can walk through the math easily, but ultimately, the longer you can have a preferential tax treatment, the more money you make from the account. The difference a few decades can make is massive.
There has been concern for years that Congress might eliminate your kids’ ability to get those decades, for example, by forcing your beneficiaries to take all of the money from the retirement account over a period of a few years following your death.
But that didn’t happen in this year’s sweeping proposed tax reforms.
Leaving Retirement Plans To Kids
There are issues that arise when leaving IRAs, 401(k)’s, and other retirement plans to kids. Without planning, these funds will get managed by court-appointed guardians, will not have protection from creditors (blame the Supreme Court’s Clark v. Rameker decision for this one), will not necessarily be managed by people you trust, and will get turned over to your kids outright when they turn 18. None of that is what you want.
Enter retirement plans trusts. Retirement plans trusts (sometimes called IRA trusts) are trusts designed to be the beneficiary of retirement plans. But there’s a tax trap. If the trust is drafted wrong, the entire retirement plan will need to be distributed to the trust within five years. This is the opposite of the tax-preferential treatment people who leave their retirement plans to a trust for their kids are looking for.
The trust needs to be either a “conduit trust,” which pays all of the required minimum distributions to the beneficiaries each year, or it needs to be a “see-through” trust. Conduit trusts are safe harbors, and thus there is less risk of falling into the tax trap and they are sometimes favored by attorneys. However, they also sacrifice much of the utility of a trust, such as the ability to control the timing and amount of payments when necessary to shelter income from creditors, preserve government benefits, or for other reasons.
See-through trusts meet four criteria: (1) they are valid under state law (or would be valid but for lack of a corpus), (2) the trust must be irrevocable, or by its terms become irrevocable upon the death of the original IRA owner, (3) the trusts’s beneficiaries must all be identifiable as eligible to be designated beneficiaries (so no estates or charities, for example), and (4) a copy of the “trust documentation” must be provided to the IRA Custodian shortly after death of the plan owner (this is a concrete deadline: October 31st of the year after the year of death).
What’s more, to identify the applicable distribution period (i.e. the lifetime over which the retirement plans will be stretched), the IRS will look through the trust to find the oldest outright beneficiary. Thus if the trust is left to your daughter Alice (14 years old) and your son Bob (16 years old), but your sister Catherine (45 years old) will inherit if they both die before they reach the age of 30, the IRS looks to Catherine’s age to determine the applicable distribution period. This reduces the stretch–and the tax advantage–by thirty years. That’s thirty years of savings, tax free, that the wrong beneficiary designation can cost you.
The Bottom Line
While there is room to disagree about many elements of the proposed tax reforms, one thing all parents and retirees can be thankful for is this: the tax-deferred savings you’ve collected all your life can still be saved for your children. Understanding the rules–and working with an estate planner who understands them–can give you and your kids or grandkids extra decades of preferential tax treatment on the retirement plans you leave behind. That extra money can be the difference that lets them retire or even start a second career later in life.
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Tom White writes “A Little Deathy.” He is Attorney/Owner of King County Business Law in Seattle, Washington, is admitted to practice law in WA and NY, and is the pseudonymous author of UN-acclaimed anti-human-trafficking novel River of Innocents. He is an Eagle Scout and recipient of the Order of the Arrow’s Vigil Honor, and he volunteers at the Housing Justice Project. A graduate of Williams College and Georgetown Law, Tom can occasionally be spotted in the wild at Seattle coffee shops.
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