There have been billions of dollars invested in Individual Retirement Accounts (IRA) over the last 20 years. It has been one of the most popular alternatives for building assets for retirement. That being said, it’s important to understand the pitfalls as well as benefits of this retirement plan.
The benefits of having an IRA are:
- A. Contributions are tax deductible from current earnings.
- B. Many investment options are available.
- C. Investment grows tax-free while in the plan.
For these reasons, IRAs are excellent vehicles for accumulating money for later use, usually for income at retirement.
These plans have pitfalls that are not often considered as part of an overall planning process, which may cause dilemmas to the retiree and heirs. They are:
- A. Early withdrawals, prior to age 59½, are exposed to income tax and penalties.
- B. The IRS requires the owner to take required minimum distributions (RMD), after reaching age 70 ½, whether desired or not. The amount of income is based on a formula. These, like any other IRA distributions, are subject to income tax in the year of distribution.
- C. SINCE ALL DISTRIBUTIONS ARE SUBJECT TO INCOME TAX, THE BIGGEST DILEMMA OCCURS AT THE TIME THE IRA OWNER DIES, LEAVING THE IRA ASSETS TO HEIRS.
- A. Tax deferral for the heirs on the account balance, allowing account growth for a longer period of time
- B. With a spouse as beneficiary, the marital deduction will shield the account from the estate tax at the participant’s death.
- C. Significant account values can be passed on to heirs without contributions on their parts.
- A. If the tax laws change, the beneficiaries may have more of a tax burden than expected.
- B. Beneficiaries must take RMD (required minimum disbursements) when applicable. Unless there is a reasonable cause for missing a RMD, the IRS may asses a 50% penalty, (50% of the distribution that should have been taken).
Unlike other appreciated assets in an estate, IRA assets at death, do not receive a “step up in basis” for income tax purposes. All the money in the plan, including contributions and growth, is subject to income tax when received by a beneficiary. This TAX BILL often comes as a BIG surprise.
WHAT IS A “STRETCH” IRA
While many people have an IRA account for retirement income, others may prefer to pass the tax-deferred savings on to their beneficiaries. For this latter group a “stretch” IRA may be a good alternative. A “stretch” IRA can defer income taxes for beneficiaries. Properly established “stretch” IRAs may actually defer taxes for multiple generations, and can be an excellent tax-planning tool.
In the past, a non-spousal beneficiary would often cash out an inherited IRA, requiring payment of income taxes on the entire amount. Now, there are choices. IRA funds can continue to grow tax-deferred for a long period of time. The beneficiary only has to pay income taxes on the amounts withdrawn each year, rather than on a lump sum.
HOW TO ESTABLISH A “STRETCH” IRA
The first step is to designate beneficiaries. This effectively extends the payment of the RMD (required minimum distributions) over the beneficiaries’ lives. If there are multiple beneficiaries, they generally must begin taking distributions from the IRA based on the life expectancy of the oldest beneficiary. However, the IRA account can be split into separate accounts by December 31st of the year following the participant’s death, so that the beneficiaries can have their shares distributed over each of their life expectancies.
The designated beneficiary may be a person or a qualifying trust. In order for a trust to be a designated beneficiary, it must be valid under state law, irrevocable at the date of death, have identifiable beneficiaries, and a copy of the trust agreement must be provided to the plan administrator. Not all financial institutions allow stretch IRAs, so be sure yours does.
HOW IT WORKS
WHEN THE SPOUSE IS THE BENEFICIARY
The IRA owner names their spouse as beneficiary. On the death of the IRA owner, the spouse rolls over the funds into his or her own IRA and names a new beneficiary, such as a grandchild. At the age of 70 ½, the surviving spouse takes the RMD, (required minimum distributions). When the surviving spouse dies, distributions to the beneficiaries would be required.
WHEN A NON SPOUSE IS THE BENEFICIARY
When the beneficiary of the IRA is not a spouse, the deferment may not be as long, because the beneficiaries must start taking distributions in the year following the IRA owner’s death. Whereas a spousal beneficiary may wait until age 70½ to receive RMD, a non-spousal beneficiary cannot. However, the payments to the non-spousal beneficiary will be based on the beneficiary’s life expectancy, which can be for an extended period of time. The advantage of this option is that it greatly decreases the amount of the RMD each year, while allowing the account balance to grow tax-free.
A non-spousal inherited IRA must keep the name of the deceased on the account as in “John Doe,” beneficiary of “Mary Doe.” This must be accomplished by December 31st of the year following the participant’s death. It cannot be rolled over into a non-spouse’s personal IRA. A successor, (next generation), beneficiary can be named for the inherited IRA as long as the distributions from the IRA continue to meet the RMD (required minimum distribution) rules applicable to the original non-spousal beneficiary.
ADVANTAGES OF A STRETCH IRA
The advantages of a Stretch IRA are:
DISADVANTAGES OF A STRETCH IRA
The disadvantages of a Stretch IRA are:
Always seek professional tax and legal guidance to help determine if a stretch IRA is applicable to your circumstances.
Look for future “Foundation Cornerstones” to learn more about other donation options to the Bent Tree Foundation.
Neither the Bent Tree Foundation, its Board of Directors, or other affiliated associates provide financial or legal advice. Any use of ideas from this, or any other columns, should be professionally guided from legal and/or financial advisors.