How to Create and Preserve the “Stretch” IRA
The “stretch” IRA is a simple, but misunderstood concept. By naming at least a primary beneficiary on an IRA account, the required after-death distributions from an inherited IRA can be spread or “stretched” over the life of the individual beneficiary. That’s it. That is the guarantee, so to speak. The new IRS rules make this easy because all that needs to be done is name a living, breathing person on a beneficiary document. If the account is with a financial institution, they will have a ready document to complete. Be sure to keep a copy in a safe place, like a safe deposit box or a safe. Estates, charities, and trusts without the proper language cannot get the stretch because they do not have a life.
Why is the “Stretch” IRA Important?
The “stretch” IRA is important because the growth of the IRA account compounds and the longer the period of investment, the greater the compounding effect. A $6,000 IRA left for a surviving spouse who was 82 when the other spouse died can only spread the distributions over a 9.1 year period; at an 8% return assuming no distributions, the account will grow to $18,442. The same IRA left to an 8 year old grandchild will grow at 8% to $3,873,124 because the 8 year old grandchild’s life expectancy is 74.8 years. This is huge difference, obviously. In realty, these amounts would be much less because annual distributions are required from an inherited IRA. The point is that leaving some IRA monies to the younger generation is a great idea, if it is financially feasible.
Who Should be Named as a Primary Beneficiary?
Most people would want to name their spouse as the primary beneficiary. In a family situation where there is little or no wealth, that is a necessity. The surviving spouse will be able to spread distributions over his or her single life expectancy.
For families with a little or a lot of wealth, naming children and grandchildren maximizes the “stretch”. Why? Because the life of expectancy of a child or grandchild is much longer. More importantly, wealth is created faster in a tax-free account(at least initially) by leaving some IRA monies to the younger generation.
Who Should be Named as a Contingent Beneficiaries?
Contingent beneficiaries must be named because the primary beneficiary could die before the IRA owner. If there is no primary or contingent beneficiary(s), there is no stretch, and you want to preserve the stretch. You would also want to preserve the option of allowing the primary beneficiary to disclaim the IRA. Why? Because the primary beneficiary may not want the IRA in his or her estate to incur the estate tax on his or her death.
What If There is no Named Beneficiary?
If the IRA owner dies before the Required Beginning Date (RBD), then the inherited IRA must be distributed over a 5 year period beginning with the year after death. If the IRA owner dies after the RBD, then the Inherited IRA is stretched over the IRA owner’s remaining life expectancy. If the estate is named as the primary beneficiary, there is no stretch. The IRA account is income-taxed to the estate immediately. That’s in addition to the estate tax. Add the maximum federal income marginal tax rate of 35%, the state income tax rate of 5.3% and the maximum federal estate tax rates of 45%, and you have somewhere between 15% and 20% left.
In other words, there is some stretch, but nowhere near what the stretch could be if a younger person is named as the primary beneficiary.
How Do You Determine the Required Beginning Date?
The Required Beginning Date (RBD) is April 1 of the year following the year in which the IRA owner reaches the age of 70 ½. A death prior to the RBD will trigger the application of the five year rule, discussed below.
The Five-Year Rule Confusion
If a IRA owner dies before the RBD with no living individuals names as beneficiaries, the entire inherited IRA must be withdrawn by no later than the end of the year containing the IRA owner’s fifth anniversary of death. Example: John Doe dies June 30,2008 with a IRA worth $1,000,000. The account must be zeroed out by December 31, 2013.
If a IRA owner dies after the RBD with no living individual(s) named as beneficiaries, the inherited IRA is paid out over the IRA owner’s life expectancy, which could be less than five years. Example: John Doe dies on June 30, 2008. He is 95 years old. His life expectancy is 4.1 years according to the Single Life Expectancy Table (for inherited IRAs) and the expectancy used is 4.1 less 1 year or 3.1 years. So it is possible to have a payout period of less than 5 years even when the IRA owner dies after the RBD.
ROTH IRAs
Normally, distributions are not required by the RBD from ROTH IRAs unless the ROTH is an inherited ROTH IRA. Distributions must be taken from an inherited ROTH IRAs.
Beneficiary Form Mistakes
The biggest beneficiary form mistake is not naming a beneficiary. Depending on state law, the estate can become the default beneficiary.
The second biggest beneficiary form mistake is naming an estate as the beneficiary. By naming the estate as the beneficiary, a nonprobate asset is turned into a probate asset, having to be probated and causing delay in distribution. Naming an estate as the beneficiary results in immediate income taxation.
The third biggest mistake is not knowing where the form is. If your spouse or other primary beneficiary died today and you had to go home to find the form, could you lay your hands on it quickly? Suppose you can’t find it, so you call the brokerage firm. What if the broker left the firm? What if the firm merged or worse, went bankrupt. Next stop, you call the bank. Same situation if the bank merged. I have a client who was in that situation. Her husband died and she did not have the beneficiary form for a $90,000 IRA. The bank merged three times. No one had it. Fortunately, she was able to persuade the bank that since all other documents had beneficiary designations, the IRA beneficiary document must have named her as primary beneficiary. You don’t want to go through the hazzle. Keep a copy of your beneficiary form in a safe place, your safe deposit box.
How Do I Setup an Inherited IRA
The key is to keep the deceased’s name on the inherited IRA and indicate that the account is an inherited IRA. Example: John Doe IRA (deceased June 30, 2008) F/B/O Susan Doe, beneficiary. There is no formal setup required; only that the name of the deceased must be part of the name and it must be clear that the account is an inherited IRA. Failure to properly setup the inherited account will cause immediate taxation of the old IRA account.
Doesn’t the Will Cover IRAs?
No, it doesn’t. The estate plan for the IRA is the beneficiary form. IRAs do not pass on as a result of will provisions. Some attorneys do a great job in drafting a will, a credit shelter trust, a marital trust, the revocable trust, and health care proxies. They forget about the beneficiary form. It is the critical piece of the estate plan.
When Should IRAs Be Split Into Two or More Accounts?
If a IRA owner names more than one prime beneficiary, the rule is that the life expectancy used for the stretch is that for the oldest beneficiary. If the IRA owner wants to maximize the stretch, he or she should consider splitting the IRA account into two or more accounts with single prime beneficiaries named for each account. That action will allow each IRA beneficiary to use their own life expectancy.
Reasons the Stretch IRA May Not Be Important to Some People.
There are important exceptions to the desire and need for the “stretch”:
1) IRA owners are already wealthy; it may make more sense to leave some IRA monies to charity. That avoids both estate and income taxes.
2) Some IRA owners have no close relatives.
3) Some IRA owners only have older family members.
4) Some IRA owners want to control the distributions and want a trust with no special language to insure the stretch. Examples of special needs beneficiaries would be minors, the disabled, the mentally incompetent, and the unsophisticated.
5) Beneficiaries need the funds immediately to pay for estate taxes, funeral expenses, support of minor children, unpaid bills.
Naming a Charity as Beneficiary
If you are charitably inclined, naming a charity as an IRA prime beneficiary makes more sense tax-wise than naming charities in the will, which would leave the IRA to be taxed to your beneficiaries. Inheritances are tax-free. IRAs left to charities do not increase either the estate tax or income tax.
A tax trap results when an IRA has two or more prime beneficiaries, at least one of which is a charity. This causes the living person to have a “0” life expectancy, causing immediate taxation of the IRA.
Qualifying Trusts as Beneficiaries
Trusts that are qualified Conduit trusts or in other words “flow-through” trusts, are drafted so that the IRS can “see through” the trust and treat it as if it did not exist. They must name the primary beneficiary. They must specify that Minimum Required Distributions must flow through or be distributed to the named beneficiary at least annually. The trust document must be given to the financial institution having custody of the IRA account(s).
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