BC: STRETCHING IRA
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You've built up a nice pile of cash in an IRA, but you don't need the money for your retirement. You want to pass on the account to your kids. If all goes as planned, the assets in this tax-deferred account will continue to grow, perhaps well into their retirement. Even your grandchildren could benefit.
But if you want to stretch your IRA tax shelter to last an extra generation or two, your heirs need to follow some very complex rules. Any slip-up could result in accelerating the cash-out and the tax bill that goes along with it.
To show the potential of the stretch strategy, MFS Investment Management offers this illustration: Dad has $100,000 in a traditional IRA, and dies at age 68. His 58-year-old wife, who doesn't need the money, rolls over the cash into her own IRA. But she doesn't touch it until she's 70 1/2, when the IRS requires her to take annual minimum distributions. (At that age, her distributions can be spread over 27 years.) She dies at 80, having netted, after taxes, $92,820. Her daughter, Anne, who is 50, takes distributions based on her own life expectancy; by the time she dies at 77, she's received net income of $371,971. Anne's son, the grandson of the original owner, pulls out $315,467 over nine years. Total after-tax payout: $780,259 over 46 years.
Of course, this scenario is based on a number of assumptions, such as a 6% annual return on the account, 2005 tax rates and heirs who withdraw only the required minimum. "Part of this is having the confidence that your kids won't take out more," says Richard Johnson, an estate-planning lawyer with Waller Lansden Dortch & Davis in Nashville.
So it's a good idea to sit down with your heirs and explain the benefits of the stretch -- and the inadvertent ways they could bungle the whole thing. Here's how to make your IRA last for generations.
Roll over your company plan.
If maintaining the tax shelter as long as possible is important to you, roll over any money left in a 401(k) or other company plan into an IRA. (The exception could be if you have a large amount of appreciated company stock. See "Your Questions Answered," April.) Most 401(k) plans force heirs to quickly cash out.
Designate your beneficiaries.
Whether it's a new IRA or an old one, make sure you name a primary beneficiary, usually your spouse. Also designate contingent beneficiaries, perhaps your children, in case your primary beneficiary dies before you. Or you can name your grandchildren. "They have the longest life expectancy, and the money compounds longer," says Philip Kavesh, an estate-planning lawyer with Kavesh, Minor and Otis in Torrance, Cal. "A 10-year-old's minimum distribution is very small and can go into a custodial account."
If you do not designate beneficiaries, your IRA could end up in your estate. That would deny your heirs the chance to tie payouts to their own life expectancies. How fast they must withdraw depends on when you die, says Ed Slott, an IRA expert (www.irahelp.com). If there's no designated beneficiary and you die after 70 1/2, the minimum withdrawal would be based on what would have been your remaining life expectancy. If you die before 70 1/2, your heirs must cash out the entire account by the end of the fifth year following the year of your death.
Educate your spouse.
If a widow younger than 59 1/2 needs the money, she should keep it in her husband's IRA; if she rolled over the money into her own IRA, she would pay a 10% penalty on the early distributions taken before age 59 1/2. But if she continues to keep the money in her husband's account and then dies, the contingent beneficiaries would have to take distributions based on her life expectancy.
If she wants her children to be able to take withdrawals over their lifetimes, she has two choices. She can "disclaim" the money, meaning it goes directly to the contingent beneficiaries. Or she can roll over the account into her own IRA. She would then designate beneficiaries, who could take distributions based on their longer life expectancies when she dies.
Alert the next generation of the pitfalls.
Make sure your spouse and other beneficiaries don't allow an adviser to liquidate the account and cut a check. Your beneficiaries will pay taxes on the distribution and lose the chance for tax-deferred growth.
Also, note that only a surviving spouse has the right to roll over an inherited IRA into his or her own account. If your children or any other beneficiary cashes out an account in hopes of doing so, the full amount is taxable. If you have multiple beneficiaries, they may want to split your IRA into several "beneficiary IRAs" after you die. That way, says Vicky Schroebel, an MFS Investment vice-president, "each one can do the stretch the way they want. One may want to take the money and run, while another could allow the balance to grow tax-deferred."
But Slott warns that the splitting must be done correctly or the money becomes taxable. "The average bank messes this up," he says. The split must take place by the end of the year after the owner's death. Each new account must be titled "beneficiary account" or "inherited account," and the deceased owner's name must remain on each account. Then the custodian of the IRA must conduct a direct trustee-to-trustee transfer to each beneficiary account.
If stretching your IRA tax shelter to the nth degree is your ultimate goal, consider converting your IRA to a Roth. A demand that payouts start at age 70 1/2 doesn't apply to a Roth, so you could let your account grow until death. At that point, your beneficiaries could stretch payouts over their life expectancies and never owe tax on withdrawals.
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