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Stretching the Benefits of Your IRA

Stretching the Benefits of Your IRA

One of the easiest, yet most important, things you can do for estate planning is to give careful thought to naming the beneficiaries of your IRA and other qualified retirement accounts.  The beneficiary designation is a powerful estate planning tool which passes your assets by operation of law, rather than by probate – avoiding the expensive and often lengthy process of probating the will. Everyone’s financial and family situation is different which is why it makes sense to discuss your options with your CERTIFIED FINANCIAL PLANNER™ or Estate Attorney.

Retirement accounts and IRAs allow for both primary and contingent beneficiaries.  Married couples typically select their spouses as the primary beneficiary thus ensuring that the spouse retains the benefit of these assets.  The contingent beneficiaries are often their children.  However, one can choose siblings, parents, other family members or friends as they see fit.

When the account owner dies, the assets in the IRA will pass to the primary beneficiaries who survive them.  A surviving spouse may elect to transfer the assets into their own IRA; by so doing, the required minimum distributions will follow the spouse’s life expectancy table (as opposed to that of the decedent).  If the beneficiary is NOT the spouse then the IRA assets should be transferred into an Inherited IRA for the benefit of this individual.  If multiple beneficiaries are listed (for example an account that is split equally among 3 children), then separate Inherited IRA’s will need to be opened for each of the beneficiaries.

Unlike a traditional IRA where RMD’s start at age 70 1/2, the Inherited IRA requires the beneficiary to take Required Minimum Distributions in the year immediately following the decedent’s death.  However, the RMD’s are based on the beneficiary’s age; the younger the beneficiary the higher the life expectancy and thus the lower the RMD.  This is the “stretch” strategy, extending the lifetime of tax-deferred growth in the account.  The IRS Publication 590-B covers the details of distributions from IRAs (https://www.irs.gov/pub/irs-pdf/p590b.pdf). Beneficiaries of Inherited IRAs use the single life expectancy table.

As an estate planning tool, the stretch strategy is often overlooked.  If the IRA assets and income are not needed by the surviving spouse, then naming children and grandchildren or even great grandchildren as primary beneficiaries allows one to stretch the value of the account (and tax deferred growth) over multiple generations.  In 2018 there was discussion of eliminating this option with the Tax Cuts and Jobs Act, but it survived untouched and is still available in 2019.

There are a few important things to consider when using this strategy.  First, be sure that the beneficiaries are named individually.  Listing “the estate” as beneficiary (either primary or contingent) is a mistake.  The stretch strategy only works when the beneficiary is a living person.  The same is also true if one names an organization as a beneficiary.  Second, it is critical that the Inherited IRA is properly titled.  The account title must contain the decedent’s name.  Examples of correct titling would be Mary Smith IRA Decedent F/B/O Julia Smith Beneficiary or Julia Smith Inherited IRA Beneficiary of Mary Smith Decedent.  Putting the IRA in the name of a non-spouse beneficiary directly can void the benefits of the stretch strategy.  Finally, note that failure to name a beneficiary for an IRA at all and having it pass through a will, also derails the stretch strategy.

IRA Beneficiaries

When naming a younger person, such as a grandchild or great grandchild, there are a few other considerations. If your beneficiary is a minor, a custodian will need to be named for the account until the child reaches the age of majority (generally 18 or 21 but varies state to state). You will also want to consider the beneficiary’s ability to handle money once they reach the age of majority. Adult beneficiaries have access to the entire sum of money without restrictions; distributions are not limited to the RMD amount. Obviously, this would negate the stretch benefit of this strategy and could place large sums of money in the hands of those who are not financially responsible. Generation Skipping Taxes (GST) may also be a factor when naming a grandchild as your beneficiary on your IRA.  For 2019 if your estate is larger than $11.4 million your estate may owe GST on the amount bequest to those that are more than one generation younger than you. The GST rate in 2019 is 40%.

The devil is in the details.  Even those with knowledge and good intent sometimes fail to follow the IRS rules regarding Inherited IRAs.  The transfer from the deceased’s IRA to the Inherited IRA must be completed by the end of the year following the year of death.  Although this seems like a long time, with complicated estates it can take years for estates to settle.  The transfer must be a trustee to trustee transfer and not a “rollover” wherein the beneficiary receives a check directly.  Finally, if the decedent was 70 ½ at the time of death, then their final RMD must be taken for their year of death based on their age.

In some circumstances a client might want to use a trust as their IRA beneficiary.  This can be done and is often recommended for asset protection or other control reasons.  Parents might be worried about lawsuits, creditor protection, divorce, or protecting an heir who is financially irresponsible or disabled.  Trusts have costs to create and maintain and they are more complex to handle.  Therefore, unless the assets or risks are significant, they are generally avoided.  Further, using a trust with multiple beneficiaries somewhat negates the benefits of the stretch strategy since required minimum distributions are based on the age of the oldest beneficiary of the trust.   The trust language must be specific to avoid unwanted consequences; for example, it must specify that distributions only go to designated beneficiaries and not to pay trust expenses.  Before naming a trust as beneficiary we recommend reviewing the pros and cons with your estate attorney thoroughly.

Finally, as your life circumstances change you need to review and update your beneficiary designations.  Divorce, marriage, births, deaths and changes in your finances or health status are all reasons to reevaluate these critical designations.  At a minimum we suggest checking these annually if you are 65 and older or every 3 years if under age 65.