Owners of traditional IRAs can use their accounts to give heirs a long-term tax planning tool.
Are you positioned to take full advantage of all the potential benefits offered by your traditional IRA? Some of its most significant uses are not even related to retirement, but to estate and gift planning. With thoughtful design and careful planning, your traditional IRA can be stretched to give a designated heir a lifetime of income.
Overview of the “Stretch” Concept
While a traditional IRA is fundamentally intended to sustain its owner during his or her retirement, tax law gives the account owner the flexibility to extend the IRA’s tax benefits to another individual. The designated beneficiary may typically be a spouse or partner, but it can be virtually anyone of the accountholder’s choosing. Advantages of designating a beneficiary include the following:
- IRA account value is excluded from probate and passed directly to the designated beneficiary.
- Default beneficiary rules are provided if there is no designated beneficiary.
- The designated beneficiary may be permitted to transfer the assets to an inherited IRA and recalculate required minimum distributions (RMDs) based on the beneficiary’s actuarial life expectancy when he or she receives the IRA. For a grandchild or great-grandchild, the new actuarial life expectancy benchmark may be many decades greater than the original account owner’s, substantially reducing the RMD for any given year and further deferring much potential tax reckoning.
- The designated beneficiary may be changed at any time during the accountholder’s lifetime, even after he or she has begun RMDs. This allows the account owner to adapt beneficiary plans as life circumstances change. Keep in mind that the designation of a non-spousal beneficiary has no effect on the RMD of the primary accountholder.
A Hypothetical Application
To see how a stretch IRA might work, consider the following purely illustrative, hypothetical example. “Joe” is planning to leave an IRA valued at $100,000 to his granddaughter, now five years old.
If Joe were to have passed away this year and designated his granddaughter as beneficiary, the granddaughter could have received the entire $100,000 inside the IRA and continued to enjoy the tax advantages of the account, assuming that Joe had made appropriate provisions for any estate tax exposure when he set up the bequest.
The granddaughter would have had to transfer the assets to an inherited IRA and take RMDs each year, but they would have been calculated to reflect her actuarial life expectancy of 77.7 years (based on the IRS Single Life Expectancy Table). Assuming her account was to have earned an annualized hypothetical average return of five percent per year, the granddaughter could have had taxable RMDs worth over $275,000 by the time she reached age 55. She also could have had a remaining account balance of $430,000 at that point, and could have taken more than the RMD at any point if needed.
On the other hand, without proper beneficiary planning and designations in place, the estate may have had to pay out the entire amount within five years, thus missing out on the continued growth potential and tax deferral. What’s more, the heir would have had no built-in mechanism for deferring her potential tax liabilities for any capital gains, interest or dividends she might receive.
Planning Considerations
Here are some of the key issues you should consider to determine whether you might be a candidate for a stretch IRA:
- How ample are your other retirement resources? The stretch concept works best for IRA owners who can afford to minimize their own withdrawals and conserve the assets within the IRA.
- How significant is your potential estate tax exposure? Your plans might be thrown off course if you need IRA assets to address estate tax liabilities.
- How important is continued tax deferral to your intended beneficiary or beneficiaries? Stretching an IRA typically offers the strongest advantages to beneficiaries who can start out with small RMDs and keep their withdrawals at the minimal level for a long period of time.
An effective stretch strategy requires accurate appraisals of both the owners’ and the intended beneficiaries’ financial strengths and needs. It also requires strong working knowledge of the estate and tax rules applicable to your circumstances, especially knowledge about alternatives that might be more efficient for your situation. Contact your financial advisor to help you determine whether a stretch IRA makes sense for you. iBi
Cathy S. Butler, CFP, CRPC is a financial advisor with the Butler/Luthy Group of Morgan Stanley. For more information, call (309) 671-2873 or visit www.morganstanleyfa.com/thebutlerluthygroup.
