Posts Tagged ‘IRA’

According to conventional wisdom you should always name your spouse as beneficiary of an IRA. Let’s smash some traditional pumpkins (I am writing this in October, after all). Read on to understand why it might be a great idea to name a trust as the beneficiary of an IRA and what some of the trade-offs of doing so are.

Standing on Tradition: Naming The Spouse As IRA Beneficiary

There really is a good reason for naming the spouse as IRA beneficiary . . . much of the time. As I have written, the beauty of an IRA is that the longer money can be allowed to languish in an IRA, the more it will grow without being burdened by taxes. Because of that, the usual thinking is to try and take out as little as possible. On the other hand, there are all sorts of tax rules about when someone MUST take distributions and how much those distributions must be. Remember the rule:

SOMEDAY, SOMEHOW, SOMEONE WILL PAY TAXES ON THE IRA.

Why Naming A Spouse The IRA Beneficiary Is So Slick (Usually)

If a spouse “inherits” an IRA, she can treat it as her own. This means she does not have to begin distributions until she is 70 ½. When she does begin taking distributions she can use a special table that assumes she has a husband 10 years younger (heh, heh, heh) even though she may have just become a widow. That means MUCH smaller mandatory distributions because they are being spread out over her life and the life of Mister-Make-Believe-Ten-Years-Younger-Romeo.

The special spousal rules for inherited IRAs also say that she can name the kids as beneficiaries and upon her death they will have separate IRAs they can take out over their life expectancies (although I have found – quite nonscientifically – that most IRAs inherited by adult children quickly become new cars or tuition payments!).

On The Other Hand . . .

Sometimes naming a spouse as IRA beneficiary is a bad idea. There may be reasons that outweigh the usual good tax reasons for naming a spouse. For example, I often encounter couples concerned about protecting assets for a surviving spouse in case he or she ever needs to go into a nursing home. An IRA left directly to a spouse will be a countable asset for Medicaid purposes. There may be other good asset protection motives involved, as well.

The solution may be to name a trust as the beneficiary of the IRA. That way, IRA assets may be protected while remaining available to benefit the surviving spouse.

There are a number of ways a trust can be designed, depending upon what the client and I are trying to accomplish. Much of how a trust will be treated depends upon whether it is something the IRS calls a “designated beneficiary.”

Is A Trust A Designated Beneficiary?

If a trust benefits only real live (as in “beating hearts living”) people then the trust will be a “designated beneficiary.” If a trust says “Mom is the primary beneficiary, then the kids” that will suffice. If the trust says “Mom may receive some, but not necessarily all benefits, then when Mom dies the North Carolina Zoo takes” the trust will not be a designated beneficiary.

If a trust is NOT a “designated beneficiary” of an IRA, then the IRA must be distributed within five years if the owner dies before 70 ½. If an IRA is not huge, being forced to completely distribute it within five years is not necessarily bad.

If the owner dies after age 70 ½, however, then the trust can take distributions over what would have been the deceased owner’s life expectancy had he been alive each year. That actually will be a bit faster than if he had been alive and married because the rules use different tables that calculate distributions as if the deceased owner were still alive and single. On the other hand, for older spouses about the same age, there may not be too much difference. The difference is if Mom had inherited directly she would have used a table that pretended there was the “Ten Year Younger Romeo” (slower distributions to account for the younger Romeo’s added life expectancy) but the trust is stuck with using a single person’s table (faster).

Bottom line: If a trust fails the “designated beneficiary” rule it means the IRA must be distributed over five years if the owner died before age 70 ½ and over the owner’s life expectancy (pretending he is alive and single) if he dies after age 70 ½.

Should Everything Be Distributed To Mom?

If we set up a trust to qualify as a “designated beneficiary” the next issue is to decide whether to make the trustee pay out to Mom all of the distributions the IRS says the trust MUST take from the IRA (this is called a “conduit trust”), or to let those IRA distributions accumulate inside the trust (where they are protected).

If the trust is a conduit trust, Mom gets all IRA distributions and she pays all income taxes (probably at her low tax rate). Also, if a trust is a conduit trust the IRA distributions can be stretched out a little bit more than if the trust was an accumulation trust. It also means that if Mom goes to the nursing home on Medicaid, all of those IRA distributions will be paid to the nursing home before Medicaid kicks in.

If the trust gives the trustee the right to accumulate IRA distributions and to decide whether to pay some, all, or none of the IRA distributions through to Mom, the IRA will be distributed to the trust slightly faster, but the assets will be safe from nursing home expenses. To the extent the trustee decides not to distribute to Mom (maybe she is in a nursing home on Medicaid) the IRA distributions being held in the trust will be subject to income taxation at much higher rates than Mom would have paid had the trustee passed the IRA distributions on to Mom. On the other had, if they were paid out to Mom, everything would be gone!

Get Help!

This is a complex topic. The purpose of this brief article was to give an overview of the possible advantages of naming a trust as IRA beneficiary. Sometimes it is a great idea, and other times it may be a really bad idea. Bring it up with your attorney or financial advisor and see what she says.

For many people, this may be a great time to kill an IRA. Dismantle it. Take it down. Cash it in. And save thousands of dollars doing it. Especially as we head into the home stretch of 2011.

Many of my financial advisor friends are now on the floor. They think I’ve “gone ‘round the bend.” Don’t worry, friends, I’m going to suggest folks come see you and ask for your help.

Why a Creative IRA-cide May Be Smart.

Many people have a huge portion of their savings tied up in an IRA. If an IRA owner needs to go into a nursing home, the IRA will be a countable asset and prevent that person from qualifying for Medicaid. The only way she will qualify is by cashing in the IRA and doing other things with the cash.

Take, for example, Irma and Ira Roth, a married couple. They have about $200,000 in Medicaid countable assets, including Ira’s $150,000 traditional IRA. Ira is about to be admitted to a nursing home.

Had all of the Roth’s assets been liquid (cash, CDs, money market), we would have qualified Ira for Medicaid by moving about $110,000 to Irma, and spending about $90,000 for Irma (home improvements, new auto, perhaps an annuity). But their assets aren’t liquid. Ira has a big IRA.

To qualify for Medicaid, Ira MUST cash-in the IRA. Because IRAs are taxable as ordinary income upon receipt of distributions, Ira and Irma will include $150,000 on their joint tax return for 2011. With no other deductions or income considered, the tax bill will be about $30,069. If Ira’s IRA is $200,000, the tax bill will rocket to $44,069.

Spread The Pain.

Had Ira and Irma had a premonition back in 2010 that Ira would be in a nursing home by 2012, they could have laid plans for the intentional demise of Ira’s IRA and saved a pile of money. In fact, by killing the IRA slowly over two years they could have lowered the tax bill by over $8,000. If the IRA had been $200,000 they would have saved almost $10,000 in taxes!

It has to do with income tax rates. Income tax rates are on a curve. $20,000 taxable income will be taxed at just a bit over 10% . . . $150,000 taxable income will be taxed at 28% . . . $200,000 at almost 33%.

By breaking up income over two or more years, the income is taxed at a lower rate. For example, the tax on $150,000 in one year is about $30,000. The tax on $75,000 is about $11,000. The tax on $75,000 in each of two years is about $22,000, compared to the tax of $30,000 on $150,000 in a single year.

For someone contemplating the real possibility of a nursing home in the next few years, there are still three months to take a planned, but hefty, installment for 2011, then look at distributions in 2012 and maybe 2013.

But Isn’t Murder Always Wrong?

In our modern, relativistic society the answer is: Not always; it depends. Especially when we’re talking about IRA killing.

I tend to be a traditionalist, and traditional teaching is to leave an IRA alone and to take as little out as possible. The traditional wisdom is based on the math undergirding the federal tax rules that apply to retirement savings.

Uncle Sam says “I’ll let you put money into this thing called an IRA. I may even give you a tax deduction for the money you put in. I won’t even tax you on the investment income and the capital gains inside the IRA. That way your IRA will grow much bigger and much faster.”

And you say, “What’s the catch?” The catch is that someday, somehow someone WILL pay taxes on that IRA. It is never a question of IF, but WHEN. That is why there are all sorts of complicated rules about when someone must start taking distributions and how big those distributions must be. Uncle Sam is impatient and wants his cut.

The beauty of an IRA depends upon two things:  The amount invested and time. The more time and the more money someone has to keep an IRA going, the more attractive it will be. On the other hand, a large IRA doesn’t do too much good if it is going to remain invested for just a little longer.

Uncle Sam isn’t completely heartless, and he certainly understands that his tax rates are on the curve I described above. In that case he doesn’t set the amount too high that an owner MUST take out every year.

But when factors other than tax rules start controlling how much must come out (perhaps even dictating that ALL must come out in the case of a nursing home placement with Medicaid) it is time to start thinking outside the tax box.

So . . . RIP IRA. But before you seriously think of killing your IRA, do run it by your financial advisor.

What does cashing in an IRA, or perhaps converting to a Roth IRA, have to do with Medicare premiums? Maybe a lot . . . a lot of your money.

Occasionally a person going into a nursing home may have to cash in an IRA. In other situations converting a traditional IRA into a Roth IRA may make financial sense. At the right time and with the right advice these may be smart moves. But there can be a hidden cost that many advisors never think of.

Medicare Premiums and Income

First a bit of background on Medicare Part B premiums. Medicare is a federal health insurance program. Part B covers visits to and services by various providers. The insured pay for coverage with premiums, usually by deductions from monthly Social Security checks.

Most Medicare enrollees (72%) have been paying $96.40 monthly Medicare premiums the past few years and may be surprised to learn that the 2011 premiums are actually $115.40 a month. But federal law provides a “hold-harmless” provision that says that for most people the premiums will not go up more than any Social Security cost of living adjustment for the year. As we all know, Social Security has not gone up the past few years, so neither have the Medicare premiums. Had there been a Social Security adjustment for 2011, the monthly premiums could have been as high as $115.40.

The other 27% are not so lucky. For people who do not have premiums deducted from their Social Security checks and for new enrollees the 2011 $115.40 a month applies.

For those pulling in a bit more than average the premiums get even steeper. Individuals with annual income of between $85,000 and $107,000, and married couples with income between $170,000 and $214,000 will pay monthly premiums of $161.50. An individual with income between $107,000 and $160,000 ($214,000 and $320,000 for a couple) will pay $230.70 monthly premiums. There are a number of other brackets that scale upwards until premiums hit $369.10 monthly. You may review the 2011 Medicare premiums, co-pays and deductibles here on this website.

The Social Security Administration looks at income reported two years ago to determine Medicare premiums. In other words, 2009 income is used to determine 2011 premiums.

The Rub: Converting IRAs to Roth IRAs

When someone cashes in an IRA – for whatever reason – the cash-in will probably be a taxable distribution. In other words, if Granddaddy converts a $100,000 IRA to a Roth IRA, he will likely have an extra $100,000 gross income for tax purposes.

The result:  If Granddaddy had other income of $40,000, with his IRA conversion he will have reportable income of $140,000. That means in two years, he will be paying $230.70 in monthly Medicare premiums (using 2011 figures). That amounts to $1,611.60 extra that year.

I am not saying converting to a Roth IRA does not make sense. It may be a great move. Do be aware of the extra costs.

A reader asked me if that was a “hidden tax” and I disagreed with him. There is nothing hidden about it!