IRA? You've got some options

Very few people have to worry about estate taxes any more. Under the Tax Cuts and Jobs Act of 2017, only estates worth more than $11.4 million are subject to estate tax.

However even fairly small estates can be subject to income tax.

Most inherited assets do not count as income. If I inherit a house worth $400,000, I do not have $400,000 worth of income. I just get the house, tax-free. But if I inherit an IRA worth $400,000, I might very well have that much income. And that is because an IRA is a “tax-deferred” asset.

An asset is “tax-deferred” if you did not pay taxes on that money when you earned it, but you do have to pay taxes later when you take it out of the account. IRAs are the most common type of tax-deferred assets, but that also applies to 401(k)s, Thrift Savings Plans (for federal employees), 403(b)s, deferred compensation, and lot of other types of accounts.

If you live long enough, at least into your 70s, you have to start taking money out of those tax-deferred accounts, and paying taxes on the withdrawals. If you inherit that kind of account, you have to take money out too, and pay taxes on it. How much you have to pay, though, depends on how you handle it.

If the amount is substantial, the worst thing you can do, when you inherit an IRA-type account, is cash it out (or roll it into a regular, non-deferred account, which has the same effect). If you do that, the whole thing becomes taxable income in one year. If the account is relatively small, that isn’t a big deal. But if the account is large, it can push you into a high tax bracket. In the example I just gave, if I cashed out that $400,000 IRA, I would have $400,000 in ordinary income, on top of whatever I actually made that year. That would push me into a really high tax bracket, not to mention costing me a lot of the tax breaks I would otherwise receive.

So, if I don’t want to pay any more taxes than I absolutely have to, what are my options?

As the person who receives the inheritance, my best option is to roll that money directly into a “beneficiary IRA”. That way I can take it out gradually over time. I will still have to pay taxes, but I will pay those taxes at a lower rate, because only a little bit of it will be taxed in any given year. A little bit of extra income each year won’t push me into a high tax bracket.

But now let’s change positions. Instead of assuming I am the person who is receiving the inheritance, let’s say that I’m the person who is going to leave the inheritance. For instance, let’s say I have a lot of money in a 401(k), and I want to leave it to my daughter. If she is responsible, I can just designate her as the death beneficiary on that account, and then remind her that she needs to get some tax advice when I die. The tax advisor can show her how to roll that into a beneficiary IRA.

But let’s say that my daughter is not very responsible. Or she may not be bright enough to remember to get tax advice when the time comes. Or maybe she has substance abuse issues. Or perhaps I am concerned that her husband not get his greedy fingers on the money.

At that point I have two options. One is to set up a “conduit trust”. I make the conduit trust the death beneficiary on the account, instead of my daughter. She is the beneficiary of the trust, but she is not in charge of the trust. I name some other relative, or a friend, or perhaps a trust company or bank, as the trustee to manage the trust. If this is done right, my daughter gets the money, but she gets it gradually over time, and taxes are only paid on the amount which is paid out each year. She won’t pay any more income tax than necessary, she doesn’t have the opportunity to blow the money, and if her husband divorces her, he can’t get the inheritance. Win-win, right?

Usually, yes. But there is one downside to a conduit trust. After I die, my daughter has the right to name her own death beneficiary on the conduit trust, to receive whatever is left of that money when she dies. That may or may not be a problem, but what if after I die, she immediately names her greedy husband, or her drug-addict boyfriend, or someone else I don’t care for? If I don’t want him to get my money under any circumstances, a conduit trust may not be the best vehicle.

Which leaves me with one more option, a “trusteed IRA”. This is similar to a conduit trust, but I move things into a specific kind of account while I am still alive. If I use a trusteed IRA, my daughter gets the same tax benefits, and money is still paid out gradually to her, over time. But she loses the opportunity to change the beneficiary after I die. Instead, I have named the person, in advance, who automatically gets the rest of that money after my daughter has passed on.

But there is also a downside of a trusteed IRA. I have to move all of those tax-deferred accounts into an account with a company which offers that particular option. Not all brokerages and financial institutions offer trusteed IRAs.

So when someone has a lot of money in tax-deferred accounts, we have a number of options for estate planning: beneficiary IRAs, conduit trusts, or trusteed IRAs. For a few people, in a few particular situations, there is not a good option, but most people can find something that will work for them.

Kenneth Kirk is an attorney and estate planner in Anchorage. This article should not be taken as legal advice in a particular situation. For specific advice, contact an estate planner.

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