Do you remember the last time you really looked at your IRA?  After the rollercoaster market of the last few weeks, you may be afraid to take a peek right now.  And you may regularly look at your investments from time to time to see if a change in asset allocation is needed, but when was the last time you did a thorough and objective review of your elections since opening the IRA?

Some of you might be scratching your heads and asking, "What elections is he talking about?"  When you open an IRA you must complete a beneficiary designation form.  That's where you name the lucky person or persons who will benefit from your IRA after you are gone.  This form is so important because your IRA will be distributed to the beneficiary on this form regardless of what is contained in your will.  This is why it is imperative to make sure that this form is filled out correctly.

Since most of you have worked hard your entire life to secure a financially sound retirement, you would like to make sure your loved ones are taken care of once you are gone.  The majority of you have already named your spouse or children as the designated beneficiaries of your IRA.  However, you might be worried about the potential incapacity of a spouse, the ability of a beneficiary to make sound financial decisions, or having a minor as a beneficiary.  These are all legitimate concerns that could be solved by naming a conduit trust which is sometimes referred to as a "see-through" trust as the designated beneficiary of your IRA.  

A conduit trust is a trust that requires the trustee to withdraw the Required Minimum Distributions (RMDs) from the retirement plan over the life expectancy of the individual trust beneficiary and distribute the RMDs to that beneficiary.  A conduit trust will be considered a qualifying trust if it meets these four requirements of the IRS:

• It must be valid under state law.
•  It must be irrevocable or become irrevocable upon the owner's death.
•  The trust's beneficiaries must be identifiable.
• The trustee of the trust must provide a copy of the trust or a list of the trust beneficiaries and their entitlements to the custodian or plan administrator by October 31 of the year after the IRA owner's death.

There is also an unwritten rule that says all trust beneficiaries must be individuals since you can lose the "stretch" period if any one of the trust beneficiaries is not a person with a life expectancy.  I know you are wondering what a "stretch" period is and we will discuss this in a bit, but let's first take a look at what this last sentence means.  Since most of you are philanthropic, the thought of naming a charity as one of the beneficiaries of the conduit trust probably crossed your mind.  However, this is a no-no as it will defeat the whole purpose of setting up the trust and will take away the qualifying trust status.  A good rule of thumb to follow when choosing beneficiaries of the trust is that if it does not have a heartbeat, then it's not going to be a designated beneficiary.

Now let's take a look at what we referred to in the previous paragraph as a "stretch" period and talk about some IRA distribution scenarios.  When most people inherit an IRA, they are overwhelmed with a large sum of money and don't always consider their options.  The natural instinct for most people is to have that money now.  The problem with this is that Uncle Sam will want his share and is going to make you pay taxes on the full amount of the distribution, assuming you had no basis in the IRA.  So that hard earned money you worked your entire life to accumulate and pass on to your loved ones has now been reduced by 35%, assuming you are in the highest tax bracket.

The other options for the beneficiary depend on the original IRA owner's death.  If the original owner had not reached age 70 1/2 before his or her death, they did not begin to take their required minimum distributions (RMDs).  Therefore, the beneficiary has five years to take all the money out of the IRA and pay taxes.  However, if the original IRA owner had reached age 70 1/2, he would have been required to begin taking his RMDs and therefore the beneficiaries could take distributions over the original owner's life expectancy.  If the beneficiary is financially savy, he may be able to "stretch" the RMDs over his own life expectancy.  This depends if the current custodian (Bank, Mutual Fund Company, etc.) of the account will let you take advantage of inherited IRA provisions.  The IRS rules related to distributions of inherited IRAs can be very confusing so setting up a conduit trust will ensure that your beneficiaries take full advantage of the most beneficial IRA distribution rules. 

A conduit trust beneficiary can "stretch" distributions once they inherit the IRA and defer the income taxes over the oldest beneficiary's estimated life expectancy instead of the original owner's life expectancy.  This allows the IRA to continue to grow tax deferred while minimizing the amount of the yearly distributions.  Let's take a look at an example and show you how "stretching" IRA distributions can create a lifetime money machine:

Jim is 75 years old and his wife Carol is 73.  Jim currently has a traditional IRA valued at $900,000 at the beginning of the year.  He has set up a conduit trust with his 40 year-old son, Scott, as the beneficiary.  Since Jim is over the age of 70 1/2, he has already started to take his RMDs.  Let's assume Jim's IRA has an annual return of 6%.  Unfortunately, Jim has an untimely death at the end of the year and he has to take his RMD for this year which is $39,301.  This is calculated based on the 22.9 distribution period from the IRS uniform life expectancy table.  So at the end of the year the IRA has a balance of $914,699 ($900,000 * 6% = $954,000 - $39,301).  The following year a RMD must be taken by the trust in the amount of $21,422, which is based on Scott's life expectancy of 42.7 years.  Assuming Scott lives to age 83 and the IRA continues to grow at 6% annually, Scott will have received $4,344,380 in distributions over his lifetime.  If Scott would have decided to cash the IRA in when Jim died, he would have received a check for $914,699 and paid income taxes of $320,145 ($914,699 * 35%).

While using a conduit trust is not necessary to take advantage of the "stretch" options for inherited IRAs, it is a great way to have control over your IRA assets post-death and it guarantees your loved ones take full advantage of this money machine.  Some added benefits you receive by placing your IRA in a conduit trust include shielding your assets from creditor claims, bankruptcy, divorce, and the beneficiary's desire to have the money now. 

The McKonly & Asbury Private Client Services Group specializes in helping families protect, enhance, and transfer their wealth and values.  If you have any questions about the contents of this article or would like to speak to someone about other advanced wealth topics, please email Grant Curry at gcurry@macpas.com.