Leaving an IRA to a loved one? How to avoid a tax bomb

Darla Mercado,CNBC
  • Naming a trust as a beneficiary of your retirement account can help protect heirs who are minors, disabled or vulnerable to creditors.
  • Failing to correctly structure your trust could accelerate the liquidation of your IRA, resulting in a massive taxable distribution.
  • Remember: Trusts only need $12,500 of taxable income in 2018 ($12,750 in 2019) in order to be subject to the top tax rate of 37 percent.

You wouldn’t trust your toddler with a pile of cash, right? Well, this
estate-planning technique may allow you to safely pass your IRA on to
future generations — if you do it right.

When it comes to naming a beneficiary of your retirement account, the first
person to come to mind is likely your spouse. Your kids, if you have
them, might be a close second.

However, your children or grandchildren won’t always be in an ideal position to
receive a windfall, particularly if they are minors, disabled or

That’s when a trust might make sense.

“The real reason for having a trust as an IRA beneficiary is because there’s
some element of control,” said Ed Slott, a CPA and founder of Ed Slott
& Co. “People who name trusts as beneficiaries are doing it to
protect a very large IRA.”

It’s easy to mess up this, however.

In the first place, not all IRA custodians permit you to list a trust on your beneficiary form.

Second, the tax code has a specific list of conditions for trusts that act as
beneficiaries to retirement accounts. Failure to closely follow the IRS
rules could result in an accelerated distribution of your IRA and a raft
of taxes.

Here’s what you should know.

Four conditions

In order for a trust to be viable as a designated beneficiary, it must meet a four-part test.

1. It must be valid under your state’s law.

2. It must be an irrevocable trust — a trust that generally can’t be
changed once it’s established — or one that will become irrevocable at
your death.

3. The beneficiaries must be identifiable from the trust document.

4. The IRA custodian or retirement plan administrator must have received a
copy of the trust by Oct. 31 of the year following the year of the IRA
owner’s death.

There is an unofficial fifth rule, according to Slott: All of the trust
beneficiaries must be actual people — not charities and not your estate.

That’s because if your beneficiaries aren’t people, then your IRA may not have a designated beneficiary at all.

In that case, your heir misses out on a key estate-planning strategy that
will allow her to “stretch” the inherited IRA by taking required minimum
distributions based on her much longer life expectancy.

Even worse, if your trust fails the test, it’s subject to the rules that
kick in when you have no designated beneficiary for your IRA.

That means your retirement account will be depleted earlier than you would have intended.

If you die before you start taking required withdrawals, which start at
age 70½, your IRA must be distributed within five years after you’ve

If you die after you started your RMDs, then your distributions will
continue to pay out over what would have been your remaining (and
presumably shorter) life expectancy .

Types of trusts

The type of trust you select as a beneficiary matters. There are generally two to choose from.

A conduit trust distributes the IRA’s RMD directly to the beneficiary.

“Grantors often set up a conduit trust if they trust the child, or if the child
isn’t in a high-risk profession,” said Stephen Bigge, a CPA and partner
with Keebler & Associates.

If you’re worried that your child is a spendthrift or that creditors may try to seize the money, consider a discretionary trust.

In this case, RMDs pass from the IRA to the trust, and the amount of money
that passes to your beneficiary is ultimately up to your trustee.

Be aware of a potential tax trap here: RMDs are taxable income to the
beneficiary when he receives it, but if the distribution is held in the
trust, then the trust will owe the taxes.

Income tax

Consider that in 2019, the top marginal income tax rate of 37 percent is at
$510,301 in taxable income for singles and head of household ($612,351
for married filing jointly).

On the other hand, the 37 percent tax rate for trusts kicks in at $12,751 in taxable income.

This can present a conundrum for the trustee overseeing a discretionary
trust, especially if the beneficiary can’t be trusted with the money.

“It’s an income tax versus fiduciary responsibility issue,” said Bigge. “You
have a $50,000 RMD. Will the trust give the money to the kid or not?”

Multiple beneficiaries

Perhaps you have several children, and you’d like to pass your IRA proceeds through a trust for their benefit.

The best way to proceed is to consider creating a trust for each child.

Separate trusts allow each beneficiary to have RMDs based on his or her own life — and they also reduce strife among heirs.

“The beneficiaries might also have different cash flow needs and different
tax loads,” said Tim Steffen, director of advanced planning at Robert W.
Baird & Co. “One might want to take the money out, the other wants
to leave the money in.”

Be sure that your trust documents clearly state the names of the beneficiaries, so that it meets the IRS four-part test.

“It’s better to name the kids individually than to do something like ‘for the benefit of my three children,'” Steffen said.

Avoid these mistakes

Naming a trust as the beneficiary of an IRA isn’t for beginners. Coordinate
with your estate-planning attorney and accountant before you proceed.

That way, you can be sure to avoid these common errors:

Inadvertently placing the IRA in the trust: If you write a check from the IRA to the trust, then you’ve botched the “stretch” IRA and you’ve just made a
taxable distribution.

Instead, set up a properly titled inherited IRA, said Slott. He provided an
example of how it should look. “John Smith, IRA Deceased 11-15-18 f/b/o ,
John Smith Family Trust, beneficiary.”

This way, you preserve the IRA and the only money that goes to the trust is the RMD.

Failing to review your beneficiary forms: Why go through the work of setting up
a trust if you’re going to omit the key step of naming it as the IRA
beneficiary? Revisit your beneficiary designations and make sure they
reflect your wishes.

If you have separate trusts for your beneficiaries, name them on the form.

Being vague about your trust details: Specificity is everything. Be sure that
your trust beneficiaries are identifiable by name, and make sure that
they are people — not charities and not your estate.


BS On Needing $1 Million To Retire

The big question people always ask when it comes to retirement is “How much money do I need to save to retire comfortably?” And the big answer ― $1 million ― sends many of us into a head-first tailspin.

But before you say, “I’ll take that cat food in bulk, please,” consider this:
A lot of what you hear in the way of retirement advice is 50 shades of wrong. And yes, I’d include the idea that you need to save $1 million in that. It’s time to rethink some popular “truths” about retirement. (No, this does not give you permission to stop saving!)

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Starting a Fix and Flip Business Part 2

Last week we outlined the difference between using a Self Directed IRA and a Self Directed IRA LLC to start a fix and flip business.

We saw the advantages and disadvantages of each strategy. But what if we wanted to actually do some the work on the property ourselves?

Can we do it? Can we get paid for it? How would we do this?

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Starting a Fix and Flip Business Part 1

Many of our clients are interested in buying fixer properties for their IRA’s to fix and flip with the profits going to their IRA accounts tax deferred (or tax-free in the case of a Roth IRA).

While this is certainly possible with a self directed IRA or Self Directed IRA LLC…is it the best or only way to accomplish your investment objective?

Not necessarily, let me explain….

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Can I Continue Retirement Saving Past Age 70 1/2?


With many people living and working longer, there are important tax saving opportunities to contribute, defer, or convert well past age 70 ½.

A nice reminder by William H. Byrnes, and Robert Bloink is in their article “The Post-70 1/2 Retirement Plan Contribution Rules” about options to continue contributions which reads in part:

The rules for post-70 ½ IRA contributions depend upon whether the account is a traditional IRA, Roth IRA or SEP IRA. Direct contributions to a traditional IRA are not permitted after the client reaches age 70 ½, although the client may roll funds from another type of retirement account into his or her traditional IRA.

Conversely, the client may contribute directly to a Roth IRA after he or she has reached age 70 ½ (up to the annual $6,500 limit, which includes a $1,000 catch up amount). Direct Roth IRA contributions, however, are subject to income limitations that apply to reduce the contribution limits for taxpayers who earn more than $184,000 (married taxpayers) or $117,000 (single taxpayers) in 2016.

This means that although you can continue to contribute to your Roth IRA if you are under the income limits, if you are over those limits you can’t do a backdoor Roth after age 70 ½. You can, however, convert some of your traditional IRA to a Roth IRA after taking our your required minimum distribution.

If you are still working, you can avoid required minimum distributions and continue contributions to your employer-sponsored 401(k) or SEP IRA. You also don’t need to start taking required minimum distributions so long as you do not own 5% or more of the company:

Clients who are still working after age 70 ½ may generally continue contributing to employer-sponsored 401(k) accounts and SEP IRAs. In fact, employers must continue to make employer contributions to the SEP IRA of an employee who is over age 70 ½ if it makes similar contributions to younger employees’ accounts.

If the client plans to work past age 70 ½, he or she can avoid RMDs by leaving the funds in the employer-sponsored 401(k). As long as the client continues to work for the same employer that sponsors that plan, and does not own 5% or more of the company, he or she can avoid taking distributions from a 401(k), thereby avoiding the associated income tax liability that those distributions generate.

There are great tax savings opportunities between age 70 ½ and age 90. Which options provide the best tax savings depends on your specific situation.

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Roth IRA Conversions Under New Tax Law

Roth IRAs have two big tax advantages

The two most-important Roth IRA tax advantages are:

Tax-Free withdrawals

Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are federal-income-tax-free and usually state-income-tax-free too. What is a qualified withdrawal? It’s one that is taken after you, as the Roth account owner, have met both of the following requirements:

1. You’ve had at least one Roth IRA open for over five years.

2. You’ve reached age 59½ or become disabled or dead.

For purposes of meeting the five-year requirement, the clock starts ticking on the first day of the tax year for which you make your initial contribution to your first Roth account. That initial contribution can be a regular annual contribution, or it can be a conversion contribution. For example, say your initial Roth pay-in was an annual contribution made on 4/1/14 for your 2013 tax year. The five-year clock started ticking on 1/1/13 (the beginning of the tax year for which the contribution was made), and you met the five-year requirement on 1/1/18.

Exempt from required minimum distribution rules

Unlike with a traditional IRA, you don’t have to start taking annual required minimum distributions (RMDs) from Roth accounts after reaching age 70½. Instead, you can leave your Roth account(s) untouched for as long as you live if you wish. This important privilege makes your Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth money to help finance your own retirement).

Making annual Roth IRA contributions

Annual Roth contributions make the most sense for those who believe they will pay the same or higher tax rates during retirement. Higher future taxes can be avoided on Roth account earnings, because qualified Roth withdrawals are federal-income-tax-free (and usually state-income-tax-free too).

The downside is you get no deductions for making Roth contributions.

So if you expect to pay lower tax rates during retirement (good luck with that), you might be better off making deductible traditional IRA contributions (assuming your income permits), because the current deductions may be worth more to you than tax-free withdrawals later on.

The other best-case scenario for annual Roth contributions is when you have maxed out on deductible retirement plan contributions. For example, you’ve contributed the maximum possible amount to your 401(k) plan at work. In that case, making Roth contributions is basically a no-brainer.

Annual contributions are limited and earned income is required

The absolute maximum amount you can contribute to a Roth account for any tax year is the lesser of: (1) your earned income for the year or (2) the annual contribution limit for the year. Basically, earned income means wage and salary income (including bonuses), self-employment income, and alimony received that is included in your gross income (believe it or not). If you are married, you can add your spouse’s earned income to the total.

For 2018, the annual Roth contribution limit is $5,500 or $6,500 if you will be age 50 or older as of year-end.

Annual contribution privilege is phased out at higher incomes

For 2018, eligibility to make annual Roth contributions is phased out between modified adjusted gross income (MAGI) of $120,000 and $135,000 for unmarried individuals.

For married joint filers, the 2018 phase-out range is between MAGI of $189,000 and $199,000.

Annual contribution deadline

The deadline for making annual Roth contributions is the same as the deadline for annual traditional IRA contributions, i.e., the original due date of your return. For example, the contribution deadline for the 2018 tax year is 4/15/19. However, you can make a 2018 contribution anytime between now and then. The sooner you contribute, the sooner you can start earning tax-free income.

Well-seasoned individuals can still make annual Roth contributions

After reaching age 70½, you can still make annual Roth IRA contributions — assuming there are no problems with the earned income limitation or the income-based phase-out rule. In contrast, you cannot make any more contributions to traditional IRAs after you reach age 70½.

Roth conversions

The quickest way to get a significant sum into a Roth IRA is by converting a traditional IRA to Roth status. The conversion is treated as a taxable distribution from your traditional IRA, because you’re deemed to receive a payout from the traditional account with the money then going into the new Roth account. So doing a conversion before year-end will trigger a bigger federal income tax bill for this year (and maybe a bigger state income tax bill too).

However, today’s federal income tax rates might be the lowest you’ll see for the rest of your life. Thanks to the TCJA, the rates shown below apply for 2018. These brackets will be adjusted for inflation for 2019-2025. In 2026, the pre-TCJA rates and brackets are scheduled to come back into force.

Single Joint HOH*

10% tax bracket $ 0-9,525 0-19,050 0-13,600

Beginning of 12% bracket 9,526 19,051 13,601

Beginning of 22 bracket 38,701 77,401 51,801

Beginning of 24% bracket 82,501 165,001 82,501

Beginning of 32% bracket 157,501 315,001 157,501

Beginning of 35% bracket 200,001 400,001 200,001

Beginning of 37% bracket 500,001 600,001 500,001

* Head of household

So if you convert in 2018, you’ll pay today’s low tax rates on the extra income triggered by the conversion and completely avoid the potential for higher future rates on all the post-conversion income that will be earned in your Roth account. That’s because Roth withdrawals taken after age 59½ are totally federal-income-tax-free, as long as you’ve had at least one Roth account open for over five years.

To be clear, the best candidates for the Roth conversion strategy are people who believe that their tax rates during retirement will be the same or higher than their current tax rates. If you fit into that category, please keep reading.

Consider multi-year conversion strategy

Converting a traditional IRA with a relatively big balance could push you into a higher tax bracket. For example, if you’re single and expect your 2018 taxable income to be about $110,000, your marginal federal income tax rate is 24%. Converting a $100,000 traditional IRA into a Roth account in 2018 would cause about half of the extra income from the conversion to be taxed at 32%. But if you spread the $100,000 conversion 50/50 over 2018 and 2019 (which you are allowed to do), almost all of the extra income from converting would be taxed at 24%.

Ill-advised conversions in 2018 and beyond cannot be reversed

For 2018 and beyond, you cannot reverse the conversion of a traditional IRA into a Roth account. Under prior law, you had until October 15 of the year after an ill-advised conversion to reverse it and thereby avoid the conversion tax hit.

2017 Conversions can still be reversed as late as Oct. 15, 2018

The IRS has clarified that if you converted a traditional IRA into a Roth account in 2017, you can reverse the conversion as long as you get it done by 10/15/18. That 10/15/18 deadline applies whether or not you extend your 2017 Form 1040.

You accomplish a Roth conversion reversal by “re-characterizing” (weird word chosen by the IRS) the Roth account back to traditional IRA status. That is done by turning in the proper form to your Roth IRA trustee or custodian.

Conclusion on conversions

Low current tax cost for converting + avoidance of possibly higher tax rates in future years on income that will accumulate in your Roth account = continuing perfect storm for the Roth conversion strategy. However, talk to your tax adviser before pulling the trigger on a conversion — just to make sure you’ve considered all the relevant factors.

The Bottom Line

Even with the new law’s dis-allowance of the Roth conversion reversal privilege, Roth IRAs are still a tax-smart retirement savings alternative for many folks. Maybe now more than ever.


Advantages Of A Revocable Living Trust

Many people believe a Last Will and Testament is sufficient to meet their estate planning goals.

If their goal is making the fulfillment of their wishes as easy as possible for their family and friends, with the least amount of expense, they might consider a Revocable Living Trust.

A Revocable Living Trust is a legal document that acts similarly to a Will, but does much more.

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