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IRA
A New Look at Stretch IRAs
By Herb White
Managing Director, Life Certain Wealth Strategies
The twenty-first century brought an influx of new wealth to holders of IRAs, 401(k)s and similar plans. That meant new tax liabilities as well. But, there is a way to extend the tax-deferred status of an IRA long after your death. Called multigenerational or "stretch" IRAs, they also are a way to, in effect, speak from the grave regarding how and when your heirs receive distributions. By naming your children or grandchildren as the beneficiaries of your retirement assets, they will be able to stretch out the annual distributions of the IRA(s) over the course of their lifetimes. And, because there is so much time for the investments in the IRAs to grow at a compounded, tax-deferred rate, the potential payouts can be significant.
IRAs have long been regarded as great retirement savings plans. They allow you to invest tax-deferred money that you can later withdraw when you’re retired, as long as you take minimum distributions (RMDs) beginning after age 70 ½. What becomes of the funds left in the IRA at your death? It is important to understand that tax liability goes with the account - it does not go away when you die. IRA rules allow only the surviving spouse to “roll over” the account into his or her own name.
Name a Younger Beneficiary
To stretch out the distributions and manage the taxes, you can name a younger person (for example, your daughter), who then has the option of also naming a beneficiary. If she designates a younger person (for example, your grandchild) the IRA you held would eventually pass to him or her, who will continue taking RMDs according to the schedule your daughter used. By spreading out or "stretching" distributions over such a long time span, you can potentially extend the life of your IRA over several generations.
The potential income stream of the stretch IRA is based on IRS guidelines that include the life expectancies of the various beneficiaries. The amount of retirement money these plans generate depends on the rate of return of the underlying investment that funds the account and the length of time the money is invested. Typical underlying investments include mutual funds, variable annuities, individual stocks, and bonds.
Consider Your Options
Traditional IRA - The spouse is the primary beneficiary and the children or grandchildren are the contingent beneficiaries. The downside is that distributions and income tax deferral are extended only through the life expectancy of the oldest beneficiary.
The Spousal Rollover - You can break up your retirement assets into several IRAs. Your spouse remains the primary heir and your children or grandchildren become the beneficiaries with their own IRA accounts. This strategy, when structured correctly, allows the distributions and income tax deferrals to extend throughout the lifetime of the beneficiaries you name.
You can add a trust into the plans. For example, you name your wife as the primary beneficiary and a bypass trust as first contingent beneficiary. The second contingent beneficiary is the children equally. The third is a trust for the grandchildren. At your death, your spouse could roll over all or part of the IRA into her IRA and could also disclaim a portion into the bypass trust.
The advantage of disclaiming to the bypass trust is that upon your wife’s death, the proceeds of the trust are not included in her estate. She could also disclaim all or part to the children, who could then take withdrawals based on their longer life expectancy. Finally, if neither your spouse nor your children need all the money, they could disclaim all or a portion to a trust for the grandchildren.
The Participant Direct approach can provide the greatest tax benefit of all. Using this strategy, you’ll be asked to break up your retirement assets into several different IRAs much as you would with the spousal rollover, but your children and grandchildren, not your spouse, are listed as the primary beneficiaries. With this method, you’ll be able to lower the amount of the minimum distributions you are forced to take out once you hit age 70-1/2, leaving more money behind for your heirs.
Naming the estate as the beneficiary is the worst possible choice. If you die prior to beginning required distributions from the IRA, the entire balance in the account that goes to the estate must be paid out, and thus is subjected to income tax, within a five-year period. If you die after distributions have begun, the balance must be paid out at least as rapidly as under the method of distribution that was in effect on the date of death. The result could be that as little as 18% of the total value of your IRA would eventually end up in the hands of your beneficiaries.
Dos and Don’ts
You do need to make a decision on whether you want to set up a multigenerational IRA by April 1 of the year after you’ve turned 70-1/2.
If you’ve accumulated a large portfolio of IRA investments - as so many baby boomers these days have - and you’re passing that on to your grandchildren, it’s wise to hold the limit to $1 million or face a generation skipping tax.
Make sure that your beneficiaries know not to dip into their money to pay off the estate tax bill.
In all cases, whether there is a "designated beneficiary" must be determined by September 30th of the year after the IRA owners death.
A final thought - done right, these stretch IRAs are a great way to provide for your family and when compared to the other choices you have, they measure up.
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