The Wall Street Journal's Kelly Greene covered a Congressional proposal to end this attractive opportunity earlier this year.

Right now, if you inherit an IRA or other tax-advantaged retirement account, you are allowed to stretch out the withdrawals, and therefore the income tax, over the course of your own life expectancy.

Estate planning attorneys have found a way to wrap asset protection around that inherited IRA by putting it into a special tax-advantaged trust.

Congress proposed to end this nice tax strategy by requiring that all inherited IRAs must be withdrawn completely (and all income taxes paid) within 5 years but abandoned that proposal. So, inherited IRAs can offer income tax deferral over decades if handled properly.

Ms. Greene’s article points out the pitfalls of leaving IRAs to beneficiaries without strategic legal planning.

Naming a Living Trust as Beneficiary

Some people name their living trust as the beneficiary of the IRA, perhaps hoping to gain the asset protection advantages of a protective trust. But a typical living trust has no life expectancy. It also doesn't have asset protection unless than was built into it. Without a life expectancy, a typical living trust cannot qualify for withdrawals over decades. The tax opportunity is lost.

Mistitling the Inherited IRA

Titling problems: When you inherit an IRA, you should retitle the account so it reads like this: “William Smith, Deceased (date of death) IRA F/B/O (for benefit of) James Smith, Beneficiary.” But Mr. Anderson is working with a client who received forms from the custodian of the account that didn't spell out that he had inherited the account. The second set of forms the client received still needed some edits to avoid possibly disqualifying the account, Mr. Anderson says.

Missing the Estate Tax Deduction

The final mistake Ms. Greene warns readers to avoid is failing to take a tax deduction against the IRA income for estate taxes paid. The estate tax is deductible against the IRA income even if the tax was paid out of other estate assets.

Mistreating Your Children

I want to add another warning to readers of this blog: don't let IRA planning end up treating your children unfairly. The child inheriting the IRA is going to have to pay income taxes against it, yes, but the child inheriting non-IRA assets is probably the one who has to pay estate taxes on all of the assets, including the IRA.

A Happy Ending

There are creative and effective ways to ensure fairness without trying to predict how much the income tax on the IRA will be (you'd need to know the inheriting child's marginal income tax rate as well as when they were going to withdraw the income and how much growth the IRA would see before they withdraw) and how much the estate tax is going to be (you'll have to predict what Congress is going to do about the exemption and predict the exact size of your estate).

As an example, use an IRA trust to name all of your children the beneficiary of so that the IRA tax deduction is shared equally, all children get a chance to postpone income taxes and all of the IRA assets are protected from divorce, lawsuits or creditors.

By Diedre Braverman

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