We’ve previously written about the power of exponential growth and what could happen if things go “right” with your retirement assets. Now let’s discuss where things often go wrong. Unless you supercharge your IRA, there’s no guarantee that your beneficiaries will take advantage of all the potential benefits your accounts can provide. Why?
Wealth Waster #1: Lots of Traps and No “Do-Overs”
When the IRA owner dies, there are many specific rules about what the beneficiary can and cannot do. There are critical filings and deadlines. Unfortunately, along the way, there are many traps that the beneficiary can fall into that “blow” the stretchout. And one mistake is all that it takes; there are no “do-overs” with these rules. If the beneficiary makes a serious error, there likely will not be any way to resolve it and still qualify for the stretchout benefit.
While you might think that your beneficiary should be able to get the proper advice from the bank or financial institution, sadly, that is often not the case. Sometimes, it’s that the advisors don’t fully understand how the stretchout benefit works or how to complete and submit the paperwork correctly. Other times, we’ve heard of advisors just giving flat out wrong advice, such as telling the beneficiary that their only option is to cash out the account, pay all the taxes, and then reinvest the remainder with the advisor in a regular brokerage account. This means that depending upon the value of your account; your beneficiary could end up paying close to 50% in income taxes between state and federal income taxes! (Which can, in turn, trigger other tax issues. For instance, if your beneficiary is retired, it could cause their social security earnings to be partially taxable or other similar problems, etc.)
Wealth Waster #2: Bad Decisions by Your Beneficiary
Did you know that most inheritances are spent within 18-36 months?
When you name a beneficiary directly on a retirement plan, it is entirely up to them as to whether they opt to cash out the account or choose the stretchout benefit option. For beneficiaries, inheritances are often like winning the lottery. There are all sorts of research and examples regarding the downside of “sudden wealth.” One of the first things many beneficiaries do is go out and purchase a new vehicle. Think about the stories you see in the news about lottery winners, professional athletes, or performers that file for bankruptcy—most beneficiaries or recipients are not prepared for the responsibility of managing a sudden windfall.
Even if your beneficiary does select the “stretchout” option, they must continue to make sound financial decisions. While the IRS rules mandate that your beneficiary must withdraw the Required Minimum Distribution each year, he or she still has the option to withdraw a larger amount or liquidate the account entirely. Therefore, your beneficiary must continually exercise good judgment and not fall victim to advisors, spouses, or others that might encourage them to liquidate the account or make other rash decisions.
Wealth Waster #3: In-Laws Turned Outlaws
In light of today's 50% divorce rate, crossing your fingers and saying “it won’t happen to my children” is probably not a good planning strategy. When your child initially inherits assets from you, they are considered “separate property” that should not be subject to division in a divorce. But over time, the wall of separation often begins to deteriorate.
Depending on how your beneficiary uses the funds from the account, an argument can be made that some or all of the funds have been converted to marital property. This becomes a concern, for example, if some of the funds are used to pay the mortgage on the marital home, purchase a vacation property, or pay for household expenses.
But let’s hope your beneficiary doesn’t get divorced. Still, consider that when they die, they will probably name their spouse as the beneficiary on the Inherited IRA. It’s likely that their surviving spouse will get remarried, possibly even have more children, etc. And now, suddenly, the Inherited IRA is subject to the poor choices and indiscretions of people you’re not even related to. Next thing you know, not a penny of the account ever makes it to your grandchildren.
Wealth Waster #4: Bad News, The Supreme Court Took Away Your Children’s IRA Protection
Perhaps, you’ve been told previously that your IRA is protected from lawsuits and creditors? That’s true.
However, in 2014, in Clark v. Rameker, the U.S. Supreme Court ruled that Inherited IRAs (i.e., the “stretchout” IRAs) are NOT protected under federal law and therefore are NOT shielded from creditors or bankruptcy.
What if your child causes a fatal car accident that leads to a large lawsuit judgment? Or what if your child has a serious medical event and the hospital bills put your child into bankruptcy (one of the most common causes of bankruptcy)?
Your child’s Inherited IRA is at risk to lawsuits and creditors.
Consider that through the power of the exponential growth on the Inherited IRA, the account could be worth significantly more in the future. The bigger the IRA, the juicier a target for lawsuits and creditors.
Wealth Waster #5: Naming a Minor as a Beneficiary
If your children or grandchildren are minors, then it’s probably not a wise idea to name them directly as beneficiaries of a retirement plan. An individual must be at least 18 years of age to legally “own” something. Therefore, if you die while your beneficiary is still a minor, a guardian will be appointed to manage the account on behalf of the minor beneficiary. On the beneficiary’s 18th birthday, he or she will be given complete access and control over the account. Do you think your beneficiary, at 18 years old, is going to make smart financial decisions at such a young age? Probably not.
Wealth Waster #6: Failing to Protect Beneficiaries who are Disabled or Have Special Needs
Do you have a beneficiary who is disabled or has special needs? If your beneficiary is the recipient of important government benefits such as Medicaid or Supplemental Security Income (SSI), then directly inheriting an IRA will likely cause them to lose their benefits. In addition, the entire IRA may end up being spent on living expenses and medical care that would have otherwise been covered by government benefits.
Even if your beneficiary is not currently disabled, things can happen to anyone, and at any time. It's always good for your planning to contemplate the possibility of a disabled beneficiary.
With proper planning, you don’t have to disinherit a beneficiary who is disabled or has special needs. Instead, you can leave funds to supplement their government benefits to help them lead a better quality of life.
Wealth Waster #7: Future Estate Taxes
Let’s assume for a moment that your child is the perfect beneficiary. Your child properly filed for the Inherited IRA “stretchout” option. Your child only takes the Required Minimum Distributions to maximize the power of continued tax-deferred growth. Your child doesn’t experience a divorce, lawsuit, bankruptcy, disability, or similar catastrophe. Your child lives into their golden years, by which time the account has grown handsomely and is now worth millions, and then your child dies leaving the account to your grandchildren. But first, BAM! Estate taxes!
As of 2018, the estate tax exemption (i.e., the amount that you can pass free of estate taxes upon death) is $11.2 Million. Any assets more than the estate tax exemption amount are taxed at a 40% tax rate. While you may not currently have an estate tax concern, if your family takes advantage of the benefit of the exponential growth on your IRAs—your grandchildren could be left with a massive estate tax bill when your child passes away. And while there is certainly no guarantee that the future estate tax rates will be the same, is it worth the risk?