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Stretch Your IRA to Last for Generations
Tax-deferred assets can grow for decades if your heirs don't make mistakes.
June 2006
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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