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Is Your IRA in the right bucket?

The weather is getting warmer, it’s raining, and the birds are singing in the mornings.  So you know what that means…

It’s time for spring cleaning!

As we clean out the garage and do yearly upkeep on our homes, we shouldn’t neglect our estate plans.  Proper maintenance is the key to the success of your living trust.  And just like your furnace has different needs than your air conditioner — so too does your retirement account have different needs than your checking account.

Retirement accounts — IRA, 401(k), and other employer-sponsored plans — aren’t just a great way to save for your retirement.  They’re also a great way to use the power of compound interest and tax-deferred growth (or tax-free growth for a Roth account) to turn thousands into millions.

I often compare a living trust to a bucket for holding money and assets.  But take a wrong turn — by using the wrong kind of bucket — and your heirs will stand by helplessly while the IRA custodian completely pays out the IRA and closes the account.

What would your heirs end up with?  No compound interest.  No tax-deferred growth.  And a giant tax bill from Uncle Sam.

This problem is actually more common than you might think.  But before we dig into how your IRA might be broken, let’s take a look at how it’s supposed to work.

Stretch Your IRA Distributions

The IRS allows an inherited IRA account to be distributed over the life of the beneficiary.  This is called “stretch out” of distributions, or a Stretch IRA.  So if you pass away leaving your IRA to your 35 year old son, the IRS uses his life expectancy to calculate minimum distributions — not yours!

Some living trusts aren’t designed to work with retirement accounts and don’t support stretch out of any kind.  These trusts force an IRA into the Five Year Rule.  That means the IRA must be completely paid out by the end of the fifth year after the owner’s death.

But some institutions don’t even give you that long.  You may be forced to take a single distribution, paying all the taxes in a single year (say hello to the 35% tax bracket if you inherited a sizable IRA). This happened to a recent client of mine.  Her father’s IRA was distributed in one large payment because the living trust didn’t meet the IRS stretch out rules.

It makes sense that the later you pay taxes, the better off you will be. Let’s take a look at an example to see just how much better is a stretch IRA than falling under the Five Year Rule.

See the Stretch in Action

Imagine you leave a $100,000 IRA to Angela, your 30-year-old daughter or granddaughter.  Angela has a professional job, putting her squarely in the 28% income tax bracket.

Angela invests the IRA in growth mutual funds.  It’s tough to predict what the stock market will do (just look at the past two years for evidence of that).  But we will assume that, over the long term, the IRA earns a 5% annual return, adjusted for inflation.  History suggests that Angela might be able to achieve a 7% return, but let’s be conservative.

The IRA With a Lump Sum Distribution

Let’s assume that Angela received her inherited IRA from a living trust just like the one my client’s father had.  Angela receives $72,000 from the original $100,000 IRA after taxes.  If Angela invests that money and never spends a cent, she could expect to have $239,643 when she retires at 65 (under the above assumptions).

That sounds pretty good.  And keep in mind that we adjusted for inflation.  If we hadn’t, the final figure would have been much higher. So the $240k figure is in today’s money, shopping at today’s prices.

The Stretch IRA is going to have to be pretty good to beat that.  Let’s see how it does…

The IRA with Stretch Out Distributions

If Angela is able to stretch out her distributions, she won’t have to pay any taxes up front.  She will have to take small distributions each year that are required by the IRS (called Required Minimum Distributions, or RMDs).  Over the next 35 years, those distributions will add up to $190,698 after taxes.

But even after all the distributions, Angela would still have $138,423 remaining in her trust (after taxes, if she took it as a lump sum payment at age 65).

The total value of Angela’s IRA over the 35 year period is $329,121.

You read that right.  The Stretch IRA beat the lump sum distribution by almost 73%.

The lump sum distribution performed respectably, getting Angela a nearly 240% return on her investment.

But would you turn down an extra 90% profit? I didn’t think so.

Now, of course, this is just an example.  But they show the tremendous growth potential of an IRA when it remains intact and is allowed to grow for decades.

Imagine fully funding the retirement of your grandchildren — before they have even graduated from college.  That’s what a stretch IRA can do for your family.

Securing Your IRA Stretch Out

By now you might be thinking, “Ok, Natalia — just tell me what I should look for on my beneficiary form.”  Unfortunately, it’s not that simple.  Two things will determine whether your IRA can be stretched out or will fall under the Five Year Rule:

  1. How your beneficiary form is filled out
  2. The terms of your revocable living trust

You will probably need the help of an attorney to sort this out — particularly if your living trust is the beneficiary of your retirement account.  One wrong step could cost your children hundreds of thousands of dollars over their lifetime.

If you have a large IRA (over $100k) and are concerned about stretch out, you might consider a Retirement Plan Trust.   It works in many ways like a living trust, but it is specifically designed to meet the IRS stretch out rules for retirement accounts.

Call our office if you would like to discuss stretching out your retirement accounts or want to learn more about the Retirement Plan Trust.

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The estate tax is gone, but don’t celebrate yet

We are seven weeks into the new year and there is still no clear roadmap for the estate tax.  It’s probably not too early to think about what might happen in 2011 — a 55% estate tax with a $1 million exemption.

But what about 2010?  Should we all be celebrating the (at least temporary) demise of the estate tax?

Not so fast…

The estate tax hasn’t been removed, it has been replaced with another tax.  The new tax is the capital gains tax.

Thousands of estates will be impacted.  In fact, the chief tax counsel for the House Ways and Means Committee (the committee responsible for writing tax bills) estimates that an additional 65,400 estates will have to pay taxes in 2010 because of the elimination of the estate tax.

If that doesn’t make any sense, then let me explain the concepts of “basis” and “step up” and how they were affected by the change in laws on January 1.

If you buy an asset (for example: a house, shares of stock) and sell it later for a profit, you have to pay capital gains taxes on the profit.  The price that you paid for the asset is called the basis.

Sometimes the basis changes.  For someone dying last year, the basis of each of their assets would change (step up) to the value of the asset on the day that person passed away.

An example might make that more clear:

Appreciated Assets in 2009 (With An Estate Tax)

  • Steve buys 100 shares of Apple, Inc. stock for $5 in 1997.  His basis for each share is $5 (the total basis is $500).
  • Steve passes away in 2008.  At the time, the shares of Apple stock are valued at $100.
  • Steve’s trust leaves the shares to his daughter Kate.  Kate’s basis in the shares steps up (changes) to their value at Steve’s death — $100 (for a total basis of $10,000).
  • Kate sells the shares in 2010 for $200 each.
  • Kate has to pay capital gains taxes on a $10,000 gain (100 shares times the difference between the sale price of $200 and the basis of $100).

Here’s how that would have looked had Steve passed away under the laws as they currently stand for 2010:

Appreciated Assets in 2010 (With No Estate Tax)

  • Steve buys 100 shares of Apple, Inc. stock for $5 in 1997.  His basis for each share is $5 (the total basis is $500).
  • Steve passes away in 2010.  At the time, the shares of Apple stock are valued at $100.
  • Steve’s trust leaves the shares to his daughter Kate.  Kate’s basis in the shares does not change, but remains at $5 (for a total basis of $500).
  • Kate sells the shares in 2010 for $200 each.
  • Kate has to pay capital gains taxes on a $19,500 gain (100 shares times the difference between the sale price of $200 and the basis of $5).

Under the old estate tax system, a person could pass on assets worth $3.5 million (and for which the basis would be $3.5 million) without paying any federal taxes. Now, much smaller estates are exposed to taxes.

Congress hasn’t left us completely out in the cold, though.  In 2010 you can increase the basis of property you pass on by up to $1.3 million.  Again, let’s take a look at an example:

Using Your IRC § 1022 Basis Increase

  • An entrepreneur, Julie, starts a business with just $100,000 in seed money.
  • Julie’s business has grown to be worth $3 million when Julie passes away.
  • Julie trust leaves her business to her son, Mark.
  • Mark’s basis in the business, if he chooses to later sell his shares, can be increased to $1.4 million.  This would use the entire $1.3 million increase available to Julie.

The situation is even worse for couples.  Under the 2009 estate tax laws, all property left by the decedent to their spouse would get the setup up in basis.  Someone passing away in 2010 can only increase the basis of property left to a spouse by up to $3 million (in addition to the general basis increase of $1.3 million).

So who is at risk of additional taxes now that the estate tax is gone?  Many people could be swept up into these new taxes.  But two groups in particular should carefully consider their planning in light of the changes in the law in 2010:

  • Married couples or individuals with substantially appreciated assets or a closely-held business
  • Anyone with a net worth between about $1.5 million and $3.5 million that includes appreciated assets

If that sounds like you and your family — you’re not alone.  We could see a 1000% increase in the number of estates that owe taxes this year.  And then it’s all supposed to reset in 2011, with an estate tax at the antiquated limit of $1 million.

So this story is almost certainly not over.  Stay tuned!

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A gift to your family

I came across a link a few days ago to what was described as “the most beautiful public service announcement I have ever seen.” And I must agree.  This video was both beautiful…and touching.

One of my core beliefs is that getting an estate plan is an incredible gift — to yourself, and to your family. Just like wearing a seatbelt. You wear it to protect yourself, and to make sure you’re there to take care of the family you love.

Click on the picture below to play the video.

Embrace Life

I hope you enjoy it as much as I did.

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Is your estate worth $800,000?

How much is your estate worth to you? I don’t mean how big it would be. I mean, how much is it worth to you to have your estate handled the way you want it to be?

On Friday, we learned that Bartley King’s estate was worth $800,000.

Bartley King died on July 5, 2004. He left behind a son, two daughters, and fifteen grandchildren. Four years before Bartley died, he had executed a new will. This new will named his daughter Folan as the executor and primary beneficiary.

Bartley’s son (Robert), his other daughter (Helen), and nine of his grandchildren filed a lawsuit complaining that the new will and other estate planning steps Bartley took in 2000 were invalid. Their central arguments were that Bartley lacked the mental capacity to change his will and that Folan had taken advantage of Bartley and convinced him to change his will in her favor.

The trial was held in January 2007, and Folan won. The trial judge found no credible evidence that Bartley lacked the capacity to change his estate plan. From the victory, Folan became entitled to receive Bartley’s $1.2 million estate.

But first she had to pay her lawyers.

Folan hadn’t hired just any lawyers. She had hired K&L Gates, a mega law firm with 35 offices and 1800 lawyers scattered around the globe.

A law firm like K&L Gates doesn’t come cheap. Despite the case being rather straightforward (the trial judge said it wasn’t “overly complex”), K&L Gates had a total of 18 attorneys and paralegals on the case.

The final tab for those 18 expensive professionals? $710,321.50

Throw in another $95,868.47 in costs (things like copies, legal research, and travel), and the total came to $806,189.97.

Folan spent over two-thirds of her father’s estate defending a lawsuit from her siblings, nieces, and nephews (and perhaps even her own children — that’s not clear from what I have read).

Of course, that’s not the end of the story. The trial judge originally awarded Folan $574,321.50 in attorneys fees and costs — to be paid by her brother, sister, and other relatives who had sued! This past Friday, the Massachusetts Supreme Judicial Court overturned the award and asked the trial court to reconsider.

So where is all this leading?

It’s anyone’s guess how the fees will shake out. But it doesn’t really matter what the final bill is for Folan or how much her relatives have to pay.

The tragedy has already happened. All they’re doing now is sorting out how much it will cost and who is going to pay for it.

Anyone who is thinking of treating some children or family members differently than others may be faced with the same difficulties.

There’s no right or wrong way to handle the situation. Any solution is going to be based on family history, personalities, and some judgment calls.

But there is one step you can take that will almost certainly help, creating a living trust.

In Illinois, your spouse and children must generally be given a copy of your will — even if they aren’t named as beneficiaries or are specifically disinherited. And the entire process of executing the will is played out in open court, for everyone to see.

How much you had (or didn’t have). Who got what. Anyone can go find those things out.

A trust, on the other hand, is private. You aren’t required to provide a copy of your trust to your children or anyone else who might be interested in your estate plan. No one will know anything about how your trust works except your trustee and your beneficiaries.

It’s just another one of the advantages of using a living trust over using only a will — the ability to plan your estate in privacy, and hopefully in a way that won’t ruffle anyone’s feathers.

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The power of attorney (not just) for property

With the rise of revocable living trusts for estate planning, the durable power of attorney has often been pushed into the background. But is is still a very important tool, even if most or all of your property is owned by a trust.

The ability to name an agent through a power of attorney is very flexible. You can give as few or as many powers to your agent as you wish. These are some of the more useful things an agent can do for you:

  1. Apply for public benefits for you. Your agent can file on your behalf to receive SSI or Medicaid benefits. Medicaid is an important way that many people use to pay for their nursing home care — something I will be discussing more in the coming weeks.
  2. Manage property not owned by your living trust. Unless an irrevocable life insurance trust is used, people often own life insurance in their own name. Your agent can also manage your IRA accounts, 401(k) accounts, or company pension account that an incapacity trustee would not be able to help with.
  3. Sign contracts on your behalf. Your agent can sign contracts for you, such as nursing home admission papers.
  4. Hire an attorney. An agent can hire an attorney to represent you in a variety of matters — medicaid planning, filing a lawsuit, filing for bankruptcy.
  5. Make gifts for planning purposes. You can authorize your agent to make gifts on your behalf for tax planning or Medicaid planning purposes.
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