Children don't always grow up to be the responsible types we hope for. My client Anne is divorced, with a traditional individual retirement account valued at $1 million.
Children don't always grow up to be the responsible types we hope for. My client Anne is divorced, with a traditional individual retirement account valued at $1 million. She loves her adult children, but she worries about leaving them money after she dies. Still, Anne wants to do right by her children.
Regarding her son, she said: "The first thing Fred will do is quit his job and buy that red sports car he's been talking about. He'll live the high life, wining and dining his lady friends. He's already a borderline alcoholic, and getting a "big chunk of dough" won't do him any good.
And regarding her daughter, Anne said: "Cindy's a good kid, but she lacks judgment, and her husband is no good. If she inherits my money, she'll give it to him — and to her friends to whom she can't say no."
There is another big problem, and it is called income in respect of a decedent. If Anne's children inherit her $1 million IRA and cash it out immediately, the inheritance will be considered untaxed ordinary income or income in respect of a decedent.
The federal and state taxes that would apply under IRD would shrink the value of their respective inheritances by nearly 40%. Ouch.
That much tax would reduce their $500,000 inheritances by $200,000 — leaving just $300,000 for each. That is exactly the type of big tax bite Anne wants to avoid.
I understand Anne's heartfelt concerns about her children's lack of financial wisdom.
I agree with Anne's desire to continue an annual gifting program for her kids even after death (at present, she gives each a sum of money on their birthdays). I consider it common sense for Anne to want to avoid IRA shrinkage due to the IRD tax situation.
And because I am aware that she makes charitable contributions to several worthy causes, I suggested a birthday gift annuity, also known as a testamentary gift annuity.
Here is how it works:
Following Anne's death, her children will receive a cash birthday gift each year.
For example, if she dies in the near future, 53-year-old Fred will get an annuity birthday check of $27,500 ($500,000 x 5.5% payout rate; the percentage is based on age when gift annuity starts). If he lives 30 more years to age 83, he will have received $825,000 over his lifetime.
Cindy, 50, will get an annuity of $26,500 ($500,000 x 5.3% payout rate based on her age). Assuming that she lives 33 more years, her payments will be $874,500.
The children will receive their inheritance as ordinary income in measured, smaller amounts, thus keeping them out of the top tax brackets, which wouldn't be the case if her children cashed in the entire IRA.
Anne's estate will receive a partial estate tax deduction.
Once her children die and lifetime income payments cease, money remaining in the two birthday gift annuities (which may be more than the $1 million originally deposited), will go to the charitable organizations that Anne supports.
A birthday gift annuity is an easy plan to put in place.
In Anne's case, the contractual agreement is a one-page document prepared with the assistance of the foundation that will administer these birthday annuities after her death. The foundation prepared the paperwork at no cost to Anne, and the change-of-beneficiary form at her IRA custodian was an easy matter to complete.
Anne set up these birthday gift annuities by first designating her foundation as the beneficiary of her IRA. Then Anne completed a separate letter of instruction that authorizes the foundation to administer the birthday (testamentary) annuities for her two children after her death.
Here is a sample of the language Anne used in her contract with the foundation:
"The gift annuity of each named income recipient shall make annual payments on or about the last day of the month preceding the birthday of that specific named income beneficiary. By accepting this bequest as herein described, The foundation agrees to pay every income recipient annually, for one life, with a payout at the standard rate the foundation pays to annuitants of their individual age as of the date of my death. Upon the death of each income recipient, the obligation to make annuity payments shall term-inate, in accordance with the provisions of the gift annuity agreement, and then the remainder shall be distributed to a list including the foundation, along with other agencies of the church and other charities."
Kathleen M. Rehl is the founder of Land O'Lakes, Fla.-based Rehl Financial Advisors and a member of the Alliance of Cambridge Advisors Inc. in Highland, Mich.
