Because the income tax on an IRA is deferred, a beneficiary who inherits an IRA is required to either:
- withdraw all the funds within 5 years of inheriting and pay the income tax due on the entire account; or
- take annual required minimum distributions (“RMD”) and pay income tax only on the annual distributions (“stretching” an IRA).
The reality is that most young people who inherit IRAs aren’t thinking of their future, so they withdraw all the funds and pay income tax on the entire account, plus the 10% penalty for those under age 59 ½. All the benefits of income tax deferral are lost.
If your beneficiary is under 18, you’ve added more costs and complications to the mix. A minor child can’t legally manage assets, so a Conservator would have to be appointed by the Probate Court. Unless there are other funds available to pay the attorneys fees, court costs and the premium for the required surety bond, at least some of the IRA would have to be liquidated, resulting in additional income tax plus the 10% penalty. At age 18, the child becomes a legal adult, takes control, and probably chooses to liquidate the balance of the IRA. That means the entire IRA is subjected to income tax and the 10% penalty, on top of the court costs, legal fees and bond premium that were already paid for the Conservatorship.
Even if a beneficiary over age 18 is tax smart, and chooses to stretch the IRA and take only the RMD, the IRA is still at risk. In 2014, the US Supreme Court ruled that an inherited IRA does not have creditor protection. That means the entire IRA would still be at risk to the beneficiary’s creditors or an ex spouse in a divorce.
There is a way you can protect the tax deferral, avoid the costs of a Conservatorship, and provide creditor protection for your young beneficiaries. A trust with the right provisions allows the RMD stretch, avoids a Conservatorship, and protects the account from creditors and divorce.
Not sure exactly what you need for you and your family? Does a trust even make sense for your situation? Reach out to schedule an appointment with our expert Estate Planning Attorneys. Call us at (770) 817-4999 or click here to send us a message.