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Heritage Design Law LLC
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Save Your IRA from Your Beneficiary's Creditors!

We all know our IRAs are protected from creditors. What most people don't know is: That protection goes away when your IRA is inherited by your beneficiaries.

That's what happened to Ruth's IRA. Ruth established an IRA in 2000 with her daughter, Heidi, as her sole beneficiary. Ruth died in 2001, and Heidi inherited Ruth's IRA. It was worth $450,000 at the time.

Heidi and her husband filed for bankruptcy in 2010. They claimed in their petition that the IRA, then worth $300,000, was exempt from the bankruptcy estate.  

The exemption under the bankruptcy code includes "retirement funds...in an account...exempt from taxation under section...408...of the Internal Revenue Code." The Trustee disagreed with Heidi's claim of exemption and argued that the account was not Heidi's "retirement funds." The The Bankruptcy Court agreed with the Trustee and disallowed the exemption. Heidi appealed. The District Court agreed with Heidi and reversed the Bankruptcy Court's decision. The Trustee appealed. The Appeals Court agreed with the Trustee and reversed the District Court's decision, so Heidi appealed. The U.S. Supreme Court decided to take the case to resolve the conflicts between the courts' decisions.

Unfortunately for Heidi, the Supreme Court agreed with the Appeals Court and the Bankruptcy Court, holding that the IRA account wasn't Heidi's "retirement funds." The account differed from a retirement account in several ways: Heidi could take funds out before she was 59 1/2, for example, so it wasn't set aside for her retirement. Heidi didn't save the money and take a deduction for it. So, for Ruth the account was "retirement funds," but for Heidi it wasn't. That's unfortunate, not only because Heidi lost her inherited IRA, but because the money is being distributed to her creditors, she ends up with $300,000 of ordinary income as well! 

So, how could Ruth have protected the IRA from the claims of Heidi's creditors? That's where a trust comes in. Property held by a trustee for Heidi's benefit would not legally be Heidi's property. Any money that Ruth put into a trust for Heidi would have been exempt from the claims of the Bankruptcy Court. 

What most people don't know is that a trust can also be the beneficiary of an IRA. As long as the trust has an individual beneficiary, it would qualify for the same distribution treatment as it did in Heidi's hands: required minimum distributions to the trust over Heidi's lifetime, plus whatever else she needed in addition. 

Lot's of people think you can't designate a trust as a beneficiary of an IRA, but you can -- you just have to do it correctly, and the trust has to be structured so it only has individual beneficiaries. 

So, if Ruth had left her IRA to a trust for Heidi's benefit, instead of to Heidi, Heidi would still have access to the retirement account today!

The moral of the story? Leaving a retirement account to your beneficiary is a great gift. An inherited IRA grows tax free, just like it does during your lifetime, and, except for minimum distributions, the beneficiary doesn't have to take money out until they need it. It can be a hazardous asset, though, because if the beneficiary gets into financial difficulties, the IRA is up for grabs by creditors, and it all comes out as taxable income to the beneficiary, even though they don't see a penny of it! 

The best way to avoid that is by using a trust as the beneficiary of your retirement account. The beneficiary can be a trustee. We usually recommend that the beneficiary have an independent co-trustee, but the beneficiary can hire and fire them. The trust receives the IRA distributions and holds them to be distributed to or for the benefit of the beneficiary. You can set it up so that the trust property, including the IRA, is not available to the creditors of the beneficiary.

So, consider designating a trust for your beneficiary, and then designating the trust as the beneficiary of your IRA.
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Here's a great way to incur taxes and penalties on your IRA!

Would you rather have IRS tax your IRA now or later? How about paying extra penalties when you do? If your answer is "later, please!" and "No thanks!," you should probably read this.

Paying the least amount of income tax on your IRA distributions is like the story of the three bears -- taking distributions too soon, too late, or just right. 

If you take money out of your IRA too soon, you get to pay taxes and penalties on the money you withdrew. If you take money out too late, you get to pay penalties on the money you should have taken out before but didn't, plus, you pay taxes on the money when you actually withdraw it.  If you take the money out just right, you just pay taxes on the amount you took out -- no penalties. 

With some exceptions, if you are under 59 and 1/2 when you get a distribution, it's too soon, and you pay an extra 10% penalty, plus the tax on what you withdrew.  If you don't take out minimum distribution amounts when you are required to, after you are 70 and 1/2, you get to pay a penalty tax on what you should have withdrawn, but didn't. 

One way to get distributions too soon, is to follow instructions. 

Huh? Yup. That's what Alvan did. He followed IRS instructions to make two "60-day rollover" distributions from his IRAs in 2008, and ended up paying taxes and penalties. 

One of the rules about 60-day rollover distributions is that you can only make one per year. Until Alvan's case, there was some professional discussion about whether the one year limitation applied to all retirement accounts, or to each one you have.  The IRS publication on IRAs said you could make one 60-day rollover from each IRA you have, even if you make more than one per year. That's what Alvan did.

Alvan had two IRAs, a traditional IRA (IRA #1) and a "rollover IRA" (IRA #2).  He was under 59 1/2.  He withdrew $65,064 from IRA #1 on April 14, 2008. That was a taxable distribution, unless he did a "60-day" rollover with it.  He then withdrew $65,64 from IRA #2 on June 6. He repaid the original $65,064 to IRA #1, apparently using the money he got from IRA #2, on June 10, just short of 60 days after the original distribution. Then on July 31, his wife. Elisa, withdrew $65,064 from her own traditional IRA, and Alvan repaid the $65,064 back to IRA#2 on August 4. (Unfortunately, Elisa missed her 60-day rollover deadline and didn't pay her $65,064 back to her IRA in time.)

Obviously, Alvan and Elisa were borrowing the $65,064 for some reason, and IRS objected to that. The Tax Court said that was OK, though. It doesn't matter how you use the money during the 60 days.  As long as you pay it to a qualified IRA in time, you're OK. 

However, the Tax Court said the IRS instructions were wrong. That meant that Alvan's second rollover was not a qualified rollover -- it was a taxable distribution. Since he hadn't reported the distribution as income for 2008, he was subject to penalties for under-reporting his income. Plus, a 10% penalty for the early distribution. Alvan said he ought to get some relief from the tax penalties because he relied on the IRS publication, but the Tax Court said "no" to that. 

It didn't help that Alvan is an attorney specializing in tax matters. The Tax Court said he should have known better. I'm an attorney. I have to ask myself if I would have known better. I'm not sure I would have. The statute seems pretty unambiguous, but if IRS says you can make a 60-day rollover from each retirement account, well....

Anyway, Alvan and Elisa ended up paying taxes on both Alvan's second $65,064 distribution and Elisa's, plus penalties, plus interest. Not a good result. 

The lessons? 

First, you can only make one 60-day rollover in any 12-month period. It doesn't matter how many IRAs you have. You only get one per year. 

Second, be careful when you follow IRS instructions.  If you've got any question at all about the tax treatment of a distribution, seek professional advice.  (But maybe not Alvan's.
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Online services make it possible for the “do-it-yourself-er” to accomplish their objectives without the need to hire a lawyer.  In general, that’s a good thing, but there are risks.  What you don’t know can hurt you.

I now represent a client who had previously established a series of limited liability companies. To get started he went online and filed certificates of organization, and then went online again and generated the operating agreements with LegalZoom. 

Then he ran into trouble.  All of the operating agreements have to be re-written, by an attorney. The issues he ran into weren't covered by the documents he got from LegalZoom.  Fixing his problems is harder and requires more work than doing it right would have.

In a recent commentary on CNN, Benjamin H. Barton, a Distinguished Professor of Law at the University of Tennessee observed that the legal profession is shrinking because of the advent of online services like Google, LegalZoom and Rocket Lawyer.  He says the “glass is half full” though, because it will make legal transaction costs decline. He suggests that probate costs will shrink, because more Americans will have wills, and corporations will make their products cheaper for the consumer, or pass the savings on to shareholders.  

“Only the most complicated, important and interesting work will remain. … Lawyers will ‘practice at the top of their license.’”

In my experience, lawyers already practice at the top of their license – or they are not practicing. Repetitive and simple activities get delegated to non-lawyers.

I doubt that online automation will make life less expensive for consumers. Given recent trends, I’d be inclined to believe that the savings in corporate legal fees will end up in the hands of their shareholders and highly paid executives, not in a decline in consumer prices.

The highest costs of probate result from disputes among family members. Those will occur no matter how cheap the will was.  In fact, the cheaper the will, the more likely disputes will happen!  Why? Because word processors don’t give advice.

Making good legal decisions requires counselling and advice from experienced professionals.  That’s practicing “at the top of your license” as an attorney. Word processing technology allows lawyers to spend more time counselling clients, finding creative solutions to their problems, and helping them carefully consider the options.

So, I’m not convinced that cheaper availability of legal information and documents is a “glass half full” for the consumer. I suspect that in many cases it’s going to create more work for lawyers, practicing “at the top of their license,” fixing problems that could have been avoided in the first place.
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How Today's Estate Planning Decisions Affect Your IRA

It's important to understand the long-term effects for inherited IRAs that result from decisions you make today in estate planning. Here are some key points to consider. 
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Understanding the Alphabet Soup of Trusts

The "alphabet soup" of abbreviations for different kinds of trust can be confusing, so it makes sense to have an overall understanding of the two basic types -- revocable and irrevocable. Here's a link to an article on our website about that.
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Will Your Health Care Proxy Work?

We just published a new page on how to make health care directives work.  
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