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Estate Planning Red Flag

You are leaving your IRA to a child

Many people designate a child or other young person as beneficiary of an IRA. An advantage of these “inherited IRAs” is that beneficiaries can stretch required minimum distributions (RMDs) over their life expectancies, allowing the IRA to continue growing on a tax-deferred basis for many years.

But there is also a downside: Unless the child is a minor, he or she obtains full control over the IRA, so there is nothing to stop him or her from taking larger distributions or even cashing out the entire account. And a young person may be less likely to value the tax benefits of limiting his or her withdrawals to RMDs.

One solution that allows you to preserve your IRA for as long as possible is to name a trust as its beneficiary and then name the child as the trust’s beneficiary. When you die, the trust owns the IRA, receives RMDs and makes distributions to the beneficiary according to your wishes. If the trust is structured properly, RMDs are determined based on the oldest beneficiary’s life expectancy. Alternatively, you might decide that separate trusts for each beneficiary would be preferred, thereby allowing the RMD to be based on each separate beneficiary’s age.

When leaving an IRA to a trust, careful planning is critical. If the trust does not meet specific requirements, you may inadvertently accelerate income taxes on the IRA’s assets.

Also, keep in mind that any RMDs retained in an “accumulation” trust will be taxed at trust income tax rates, which may be substantially higher than your beneficiaries’ individual rates. To avoid these taxes, the trustee can pass RMDs out to the trust beneficiaries, though doing so limits the trust’s ability to preserve the IRA’s assets.

Two other options are a conduit trust or a trusteed IRA. Both require the trustee to distribute RMDs to the beneficiaries, but they allow you to restrict additional distributions as you see fit. Trusteed IRAs, offered by many financial institutions, might be the simplest solution, but they require you to accept the financial institution as trustee.

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