Stretch IRA – The Rest of the Story

And Now You Know the Rest of the Story . . .

On November 24, 2010, we posted the blog article, “How Safe Is Your Stretch IRA?”, where we addressed several court cases in which the issue before the court was whether creditors could reach assets held by debtors in stretch IRAs. Well, your stretch IRA just got safer.

As you will recall, a stretch IRA is an individual retirement account that you inherit and then use the stretch-out provisions under the law to take payments over your lifetime (and thus defer the taxes on the distributions over your lifetime).

As we reported on November 24, 2010, several cases, including In re Chilton, had held that an inherited IRA was not entitled to the protections allowed to traditional IRAs under the Bankruptcy Code.

A district court in the Fifth Circuit has now reversed the bankruptcy court’s decision. See here. The district court noted that since the bankruptcy court’s decision, five other courts have all concluded that inherited IRAs do meet the requirements for a Bankruptcy Code exemption.

Agreeing with the reasoning of these other cases, the district court concluded that the funds in a debtor’s inherited IRA do not have to be the “retirement funds” of the debtor to satisfy the bankruptcy exemption requirements. The district court also concluded that inherited IRAs are among the IRAs that are exempt from taxation under § 408(e)(1) of the Internal Revenue Code, which provides that any individual retirement account is exempt from taxation. Because an inherited IRA meets these requirements, any differences between a traditional IRA and an inherited IRA are irrelevant for purposes of the bankruptcy exemption.

Too Good to be True?

The Portland Business Journal recently reported that Tony and Micaela Dutson were sentenced to 10 years for a tax-avoidance scheme. I represented clients that were sucked in by the Dutsons, so I am unfortunately familiar with their scheme.

The Dutsons made quite a bit of money selling abusive tax trusts. Not only did my clients pay these fees, they paid quite a bit more in penalties, interest, and attorney fees to unwind what the Dutsons had done to them. 

You may be thinking that the old adage, “if it sounds too good to be true, it probably is,” may apply here. However, there are many sophisticated tax planning ideas that my clients could have used that are perfectly legitimate to avoid paying more than their share of taxes as required under the law. Some of these ideas do sound too good to be true, but they work nonetheless.

The trick is finding competent counsel who will not lead you astray.  Micaela Dutson was an attorney, and had her certificate hung on the wall of her office showing she was a member of the Oregon State Bar. So what is a client to do? 

A client should not rely on any one professional when dealing with sophisticated tax planning. If your attorney has an idea for you, run it by your CPA. If your CPA thinks you should set up a trust, or move money offshore, ask your tax lawyer his or her opinion.

You may think this is just a ruse to get you to pay more fees by asking two professionals rather than just one, but I can tell you that as a matter of fact, I make much more money on cleaning up the messes others get into than on putting my clients into the tax planning strategies that I come up with.

How Safe Is Your Stretch IRA?

It is not hard to find reasons to be nervous about the economy and the health of our retirement nest eggs these days. The equity markets continue their multi-year run of historically high volatility, the national unemployment rate only recently dropped into the single digits and the explosion of home foreclosures continues its downward pressure on housing prices.

Another bleak subject in today’s headlines is the record number of U.S. citizens and companies filing for bankruptcy protection. According to a report earlier this month from the Administrative Office of the U.S. Courts, there were over 1.5 million bankruptcy cases filed in the Federal Courts in fiscal year 2010, up over 13% from 2009 (and five times the number of cases reported in 1980)

During a bankruptcy proceeding, the petitioner prepares a schedule of his or her assets and then the court oversees the liquidation of the assets based on the type of bankruptcy filing. Two of the most common types of filings are a Chapter 13, where a petitioner (usually a corporation) agrees to a payment plan that will reimburse creditors for a portion of the money owed them, and a Chapter 7, where the court will discharge an individual’s debt and the person will essentially start a new financial life. During these proceedings, certain assets of the debtor are protected from creditor claims, these are called exempt assets.

It is important to note that in determining the exempt/non-exempt status of assets, the court must look to both federal and state rules. It is the federal rules which outline the bankruptcy proceeding, yet state laws can also come into play when they involve state protective statutes, state trust statutes, real estate statutes, etc. In the case of the Chapter 7 filings, there are some recent state court decisions that throw into question exactly which assets are exempt from the bankruptcy judgment and these cases are illustrative of the measures that creditors are going to in an effort to reach debtors’ assets in these turbulent financial times. This case law, along with different state exemption laws, should give pause to individuals that are inheriting IRAs and planning on utilizing the stretch-out provisions to take payments over their own life expectancy (called the stretch IRA strategy).

The first two cases are In re Chilton (where a Texas bankruptcy court found that inherited IRAs are not entitled to protection) and In re Nessa, where a Minnesota bankruptcy court came to the opposite conclusion. Further, in In re McClelland, an Idaho court allowed for a state exemption to stand, yet courts in California, Oklahoma and Texas (among others) have disallowed these protections. Finally, in Robertson v. Deeb, a Florida court allowed the state exemption to apply, but then ruled that Inherited IRAs were not protected under the Florida rule due to the changes that happen to an IRA (from a tax standpoint) at the moment it is inherited. These cases illustrate the different impact that state statutes – and the strength of individual arguments in these state courthouses – have on the protections available to an individual inheriting one of these accounts.

The case law is largely silent on this issue in Oregon and Washington, however analyzing the statutes suggests that inherited IRAs may be better protected here than in other parts of the country. 

In Oregon, we look to ORS 18.358(e)(2) which says “a beneficiary’s interest in a retirement plan shall be exempt, effective without necessity of claim thereof, from execution and all other process, mesne or final.” This language would seem to exempt inherited IRAs entirely, however it is worth noting that in Robertson v. Deeb the court spent a good deal of time analyzing the statutory language in Fla. Stat. 222.21(a)(2008) to determine exactly what the Florida legislature meant by the word ‘beneficiary’. Under such analysis, ORS 18.358 may leave the door open to creditors attacking inherited IRAs because the statute defines a beneficiary only as, “a person for whom retirement plan benefits are provided and their spouse”. A court may interpret this language to exclude individuals that inherit IRA accounts and, if that is the case, the statutory protections may not apply.

In Washington, the controlling statute offers more protections. RCW 6.15.020 specifically lists IRA (and Roth IRA) accounts as types of ‘employee benefit plans’ and then declares, “The right of a person to a pension, annuity, or retirement allowance or disability allowance, or death benefits, or any optional benefit, or any other right accrued or accruing to any citizen of the state of Washington under any employee benefit plan, and any fund created by such a plan or arrangement, shall be exempt from execution, attachment, garnishment, or seizure by or under any legal process whatever.”

From a planning standpoint, the levels of protection available to these Inherited IRAs are uncertain and under a lot of scrutiny in courtrooms today. On first reading, the Revidsed Code of Washington offers more concrete protections than the language in the Oregon Revised Statutes, however we have now seen courts across the country develop very different interpretations of the federal and state protections allowed to petitioners’ interests in these inherited accounts. The bottom line? One way to shield these assets from claims, regardless of the state you live in, may be to place these inherited assets into a trust. Consult an estate planning attorney to see if this option may be right for you. 

Sitting on Pins and Needles

We recently received a report stating that Senator Jon Kyle of the Senate Finance Committee is working with fellow committee member Senator Blanche Lincoln, along with Finance Committee Chair Max Baucus and Ranking Minority Member Chuck Grassley, on an agreement to move forward on estate tax legislation. Senator Kyle stated that they have worked out the details, and are simply finding the last few offsets before bringing the bill out of committee. It appears that they will not make the law retroactive, giving us lawyers plenty of work for the next few years.

The Song Remains The Same

Surprise, surprise! Congress still has not come up with an answer to the lingering estate and generation-skipping transfer (GST) tax question for individuals who die this year. And, with the lack of a step-up in basis, some heirs will face higher combined estate and income tax costs for deaths occurring this year rather than in 2009. What a topsy-turvy world we live in.

There is still a possibility that Congress will retroactively reinstate the estate and GST taxes to the beginning of the year, but as each day goes by, this gets more and more unlikely. Even if the House could get their act together, I would be surprised to see anything come out of the Senate Finance Committee.

Apart from tax uncertainty, the continuing inaction could also pose a problem for individuals with wills using formula clauses. These clauses work well when the estate tax is in force but they may produce unintended consequences when there is no estate tax. Action may need to be taken if it becomes clear that Congress will not be addressing the situation.

Buy Now, Pay Later

I have spoken with several charities lately regarding their fundraising efforts. It seems that when the economy goes south, the charities take it on the chin more than other businesses. This is due to the fact that they rely on charitable contributions to operate. For many of these charities, now, more than ever, is when they need charitable contributions to fulfill their mission.

If you are charitably inclined, there are tax-advantaged ways to make a gift to a favorite charity while enjoying the income from that gift during your lifetime. Many educational and charitable organizations offer plans that combine the benefits of an immediate income tax deduction and lifetime income from the charitable gift. In most cases, you can make the gift in cash or securities. Here is a brief overview of the major types of deferred charitable gifts.

(1) A pooled income fund is probably the most common type of deferred giving plan. It closely resembles a mutual fund. When you make a gift to a pooled income fund, it is merged with gifts of other donors, and you receive your allocable share of the income earned by the fund. Distributions from the fund are usually made quarterly and are taxable as ordinary income. There is no guarantee as to the rate of earnings; that depends on the fund’s success.

You get an immediate income tax deduction for the year in which you make a gift to a pooled income fund. The amount of your deduction depends on a combination of your age and the fund’s highest rate of earnings in the previous three years. The deduction will be less than the full value of your contribution, because it represents the present value of the funds that the charity will withdraw from the fund after your death.

(2) In a charitable remainder unitrust (CRUT), a separate fund is set up to hold your gift until your death, at which time it will become the charity’s property. You decide at the outset on the annual percentage of the fair market value of the assets that you are to receive as income for life. For example, you may make a $50,000 gift to a CRUT and specify an 8% return. Your annual income will be $4,000. If the value of the CRUT assets drops in the next year to only $40,000, your income that year will be $3,200. If the value goes up to $60,000 in the following year, your income that year will be $4,800.

Unlike a pooled income fund, a CRUT is handled individually. Therefore, gifts using a CRUT are usually larger than those to a pooled income fund. Just as with a pooled income fund, your deduction for a gift to a CRUT will be less than the full value of your contribution.

(3) A charitable remainder annuity trust (CRAT) is similar to a CRUT in that your gift to the charity is placed in an individual trust. The CRAT provides an annual payment of a fixed dollar amount for your lifetime. This differs from a CRUT, which provides a fixed percentage of the asset value.

For example, say that you make a $50,000 gift to a CRAT that will pay you $4,000 a year for life, after which the trust principal passes to the charity. If the CRAT earns less than $4,000 a year, it will sell assets to make up the difference. If it earns more than $4,000, it will pay you $4,000 and add the excess to the trust principal.

Your income tax deduction from a gift to a CRAT is based on your age and the amount of your annual payment. As a rule of thumb, the older you are, the larger the deduction, and the greater the annual payment, the smaller the deduction.

(4) In a charitable gift annuity, you make a gift to charity in exchange for a guaranteed income for life. This is very much like buying an annuity in the commercial marketplace, except that you get an immediate charitable deduction equal to the excess of what you paid over what the annuity is worth, based on IRS tables.
Unlike the pooled income fund, CRUT, and CRAT, your income from the charitable gift annuity is an obligation of the charity that does not depend on investment results. The rate of return on your gift annuity is not variable, as in a pooled income fund, or negotiable, as in a CRUT or CRAT. Instead, it is most likely to come from a table based on your age at the time of the gift.

A portion of each year’s payment is tax-free, because the tax law allows you to recover your original payment over your life expectancy. In the year when you buy the annuity, you get a charitable deduction for a portion of the purchase price, determined from an IRS table geared to your age.

If the idea of deferred charitable giving appeals to you, please give us a call. We can discuss the pros and cons of the various types of deferred giving, and arrive at an arrangement that is right for you.

You are not as poor as you think you are.

One of the most surprising revelations that many of my clients experience is the fact that estate/inheritance taxes will be due upon their death, unless they do some planning.  These clients have been convinced that estate/inheritance taxes only affect the rich, and since they do not perceive themselves as rich, they have nothing to worry about.

What these clients don’t realize, until our initial meeting, is what all is included in their taxable estate.  The asset most often left out is proceeds from life insurance.  If you have a million dollar life insurance policy, and you also have other assets, you will pay inheritance tax in Oregon, which has only a $1 million exclusion.

The second asset most often forgotten is retirement plans.  These amounts are not only included in your taxable estate, and therefore subject to the estate tax, but they are also, without proper planning, potentially subject to income taxes.

The third asset that people seem to forget when calculating their taxable estate is equity in their real property.  This one may seem more surprising than the others, but it happens quite frequently.

Fourth, there are assets that client’s have received from their parent’s estate planning, such as family limited partnership interests, that they tend to forget about.

For those who don’t relish the idea of paying more taxes than is required (and I have yet to meet someone who does),  I recommend having a long discussion with your estate planning attorney about what is included, and what the estate tax exemptions are currently (see earlier posts about changes in the federal estate tax exemption).

Redeal of the Repeal?

In the August 7, 2009, BNA Daily Tax Report, it was noted that Rep. Brady has proposed a permanent repeal of the estate tax.  Do you remember that old Saturday morning cartoon, I’m Just a Bill?  Well, this bill is going to continue to sit on Capitol Hill and will never become law.  You heard it here first.

So, what is to become of the repeal of the estate tax?  Most of those in the know seem to say that we are going to stay with the current $3.5 million exemption.  They are probably right.  However, I think it is dangerous to count on that happening.  Let me spell out for you a less probable, but possible scenario.

 Under current law, in 2010, the estate tax essentially goes away.  Then, in 2011, it comes back with a vengeance, at a $1 million exemption (thank you Senator Bird).  When this process was set up eight years ago, it was thought that there was no way a tax increase would be allowed, so the repeal would go on, regardless of the Bird Rule.  However, now we are in an economic crisis, and the government needs money. 

Many believe that the congressional leadership don’t want to see 2010 with the unlimited exemption, so we can expect finality this year.  It is possible, however, that the they will just punt this year.  With health care taking up the entire agenda lately, the congressional leadership could just extend the $3.5 million exemption for one year while they consider the matter.  They would likely get broad suppport for this extension.  Then, next year, they could decide that Bush’s plan was best after all, and just let the Bird Rule apply.  We would be back at a $1 million exemption without a vote for a tax increase.

You may be thinking the congressional leadership wouldn’t risk this because it affects too many of the voters, but keep two things in mind.  First, because of the recession, less people would be affected as less people will have taxable estates.  And second, the government needs money to finance the change America voted for.

Now, I agree this is not the most probable scenario.  But, it is at least possible, and because it is at least possible, we should consider it in our estate tax planning. 

The Low Hanging Fruit of Asset Protection

Most clients who come to us for asset protection are looking for an offshore trust or maybe even a domestic asset protection trust. These are both viable options to protect one’s assets. However, there are a number of simpler options that one should consider first. 

  • Liability insurance is relatively inexpensive and can cover many personal liability issues that may arise.
  •  Life insurance and annuities can be good investments and are protected from creditors.
  •  Money contributed to retirement plans are protected assets and allow for tax free savings, a double benefit.
  •  529 plans (college savings plans) are also protected assets, as well as they also grow tax free.
  •  A Qualified Personal Residences Trust protect a person’s house from creditors, and also passes the house to the next generation with minimal gift tax consequences.
  •  How one titles property, depending on the laws of your particular state, can protect that property from certain creditors.
  •  When your child turns 18, have them buy their own car rather than drive one provided by you.
  •  Put investment real estate in separate limited liability companies.
  •  Ask your parents to keep any assets you receive from them in trust for your life.

These are merely an example of several items to consider. Asset protection is a continual process, much like estate planning, to keep your hard earned assets in you and your families hands.