IRAs (Individual Retirement Accounts), Keogh Plans, Simplified Employee Pensions, 401(k) Plans, and company pension and profit sharing plans, are designed to defer tax on earnings and growth in the principal in the account to a future date. 

Q: How are IRAs taxed?

These plans make it possible to get tax-deferred accumulations of savings and earnings with the tax bill coming due as stated below:

  1. Income tax will have to be paid on the principal and accrued income when funds are withdrawn.
  2. Early withdrawals before age 59.5 years will trigger a 10% penalty.
  3. Excess contribution to a retirement plan trigger a 6% penalty.
  4. Mandatory minimum withdrawals must be made after the participant reaches age 70.5 years based on IRS tables of life expectancy. The minimum withdrawals vary depending on the age of your spouse or beneficiary. If you don't withdraw the minimum by the time you die, there is a 50% penalty.
  5. You can use IRA funds to buy certain immediate-pay annuities that guarantee to you (and perhaps a designated beneficiary) a certain amount for the rest of your life. This will meet the minimum distribution requirements.
  6. Your IRA's, Keogh Plans, pension, and profit sharing benefits are included in computing your gross estate for purposes of computing estate tax liability.

If you die with an undistributed plan, unfortunately, the money in your plan, which may be a substantial part of your estate, will be taxable income and is suspect to estate tax and possibly generation skipping tax. The amount passing to your children and grandchildren may be substantially depleted.

Q: Is there anything that can be done to change the taxation of my retirement plan when I pass on?

Yes. Consider maximizing withdrawals and investing in an appropriate insurance program, creating a tax shelter irrevocable life insurance trust with annual exempt gifting by using documents that convert gifts of future interests to present interest gifts. This has been referred to as the "Last Great Tax Shelter.”

Alternatively, you can create a charitable trust for gifting under the Taxpayer Relief Act of 1997, which repealed the excise tax on transfers of IRAs to qualified charities. Transfer of the IRA or pension plan to such charities will bypass both income tax and estate tax. A Charitable Remainder Unitrust is recommended. The grantor doesn't part with anything until death of his or her survivor or the minimum period of the trust. In the meantime, the grantor receives the life income from the trust, an income tax deduction, reduction of the taxable estate for estate tax, and the gratification that comes from doing something good.

Q: If an IRA or pension plan participant dies prior to the "required beginning date," when must the plan be distributed?

The plan must distribute within 5 years of the death of the participant subject to designation of individual beneficiaries by the plan participant beginning December 31st of the calendar year of the participant's death. If the surviving spouse of the deceased participant elects, the spouse may take a lump-sum distribution and rollover all or any portion to the spouse's own IRA or treat the participant's IRA as his or her own, in order to postpone any distributions and defer income taxation until the spouse's required beginning date.

Q: Can an IRA be titled in the name of a living trust?

No, the IRA is owned by the plan participant, individually. IRAs or similar retirement plans don't require probate if the beneficiaries are named in the IRA Beneficiary Designation. A living trust isn't a person and therefore can't own an IRA. If the plan fails to name a beneficiary, probate will probably be required.

Q: Can a living trust be the beneficiary of an IRA?

Most likely, yes. Generally, a designated beneficiary must be an individual. However, if a trust meets the following requirements, the individual beneficiary of the trust who is designated as the IRA beneficiary of the trust, being the IRA beneficiary with the shortest life expectancy (i.e. the oldest beneficiary of the trust) may be treated as the designate beneficiary, subject to the following:

  1. The trust is valid under state law,
  2. The trust is irrevocable or will, by its terms, become irrevocable upon the participant's death,
  3. The beneficiaries of the trust are identified from the trust instrument, and
  4. The plan administrator, within nine months of participant's death, must be furnished with a copy of the trust instrument.
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