Passing an IRA and avoiding the big tax
With the recent changes in the tax law, the media has been in a frenzy to tell the public that the new federal ‘death tax’ not only applies to estates of $11 million per person and $22 million per married couple. This has given many the false impression that they simply do not need to do any estate planning because the assets they will pass on to their children could never meet that threshold. But what is missing from the conversation is the fact that for the majority of us, one of our biggest assets is an IRA. Unlike a house, or a traditional brokerage account, for all IRA’s other than a Roth, because you put the money in tax deferred, when the money comes out, the Government will get its share. Which means that without planning, you could be causing your children to lose up to 39.5% of the funds they may have received if they are at the top tax bracket already.
Avoiding the impact of a huge tax bill
There are ways to give your beneficiaries choices to avoid that big tax bill – but that can only be done with an estate planning professional setting up trusts for your qualified and non-qualified assets.
The stretch IRA is a wealth transfer strategy rather than a particular type of IRA. Prior to the Pension Protection Act of 2006, only spouses were eligible for the special tax treatment associated with stretch IRAs. Today, the tax law provides other family members, including children and grandchildren, with similar benefits. The stretch IRA strategy provides for a substantial tax deferral for the majority of an individual’s inherited IRA, creating a powerful and efficient wealth transfer vehicle.
Earnings from an IRA grow tax deferred, which helps investors accumulate wealth. However, investors are required to eventually withdraw the funds and are taxed on them as ordinary income (with the exception of qualified distributions from a Roth IRA, which are tax free). For traditional IRAs, required minimum distributions must begin the year the investor turns 70½.
For those investors who do not need income from the IRA, the goal is to withdraw the minimum amount required to leverage the tax-deferred benefits of the IRA in order to continue to compound growth on the maximum amount of assets possible for as long as possible – which is why the stretch IRA strategy is so powerful. It enables the investor to extend the life of the IRA so the beneficiaries can receive distributions from the IRA over a longer period. A designated beneficiary is the individual(s) chosen by the IRA owner to receive the IRA assets after the owner dies.
How Does It Work?
Assume you are the original IRA account owner and you name your spouse, child or even grandchild as your beneficiary. If your spouse is your primary beneficiary, he or she will receive those assets after you pass and can treat those IRA assets as if they are his or her own IRA and then name another beneficiary. There would be no income tax due at this time. Should a nonspouse beneficiary receive the assets, he or she would take minimum distributions based on life expectancy. Heirs will only pay income tax due on the distribution at the time they withdraw funds from the account. Therefore, receiving smaller distribution amounts each year will result in a lower tax liability, thus allow the remaining balance in the IRA to continue to grow on a tax-deferred basis.
Example: Adam started with a $300,000 IRA and took required minimum distributions starting at age 71.5 for two years. When he passed away at age 73, his IRA passed to his wife, Melissa, age 66, who as the spouse, waited until she turned age 70.5 and then took RMDs from Brian’s inherited IRA for eight years. When Melissa passed away at 77, her son Jake, age 53, inherited the account and received distribution income for more than 23 years. When he died at age 75, his son Jon, age 41, received distribution income over the next nine years until the account was depleted. In total, the family received more than $2 million from Brian’s original $300,000 IRA by using the stretch IRA strategy and spreading payouts over three generations and a 46-year time period.
Elements Of A Successful Stretch Strategy
In order to achieve the maximum benefit from a stretch IRA strategy, it is important to:
Confirm your custodian provides for the stretch strategy, as many do not.
Assign the appropriate primary and secondary beneficiaries.
Limit the amount of withdrawals from the IRA account. If too much is withdrawn, this strategy loses its benefit. The beneficiaries should request to take withdrawals based on their remaining life expectancies at the death of the IRA owner to minimize distributions.
As illustrated in the example above, the benefits to maximizing a stretch IRA strategy can be extremely powerful; however, as with any investment strategy, one must carefully consider the drawbacks as well as the benefits. There are several important considerations when choosing to use a stretch IRA strategy:
Inflation and market risk may impact the value of the assets over time.
If an RMD is missed, the IRS may assess a 50 percent penalty on the amount of the missed distribution. Even in years when the beneficiary decides to take more than the RMD, the following year the RMD must be taken.
The benefits of the stretch strategy may be negatively impacted if the original investor or a beneficiary withdraws more than the required minimum distribution amount.
When implementing a stretch IRA strategy, it is also important to ensure beneficiary designations have been made, as only designated beneficiaries may qualify for the stretch IRA. This strategy is not available if the estate or a charity is named as a beneficiary.
Often, IRA owners will name their multiple children as beneficiaries. However, this may not be the most efficient way of passing along these assets. Instead, owners may wish to consider splitting the single IRA into multiple IRAs (one for each primary beneficiary) while they are alive, so each beneficiary will have the ability to stretch distributions over his or her own life expectancy. Alternatively, the IRA can be split into multiple IRAs after the owner’s death. Investors may also wish to consider designating a younger beneficiary, thus decreasing the amount of the RMD and allowing more assets to grow tax-deferred in the account.
All these tax strategies are available as part of your estate plan that ideally should be done early so that you can not only plan for your retirement but also make considerations on how best to pass on your assets to the next generation and beyond.