Congress has considered for some time limiting the benefits of inherited IRAs — particularly the strategy called "stretching" the IRA.
Currently, the stretch strategy allows heirs of inherited IRAs to withdraw the assets over the course of their lifetime, "stretching" the tax consequences over that time period and allowing the assets to potentially grow tax deferred for some years. Various ideas have been proposed in Washington over the past year that would limit the amount of time an inheritor of an IRA has to withdraw all the assets in the account. A compressed time frame would allow the government quicker access to taxes on those IRA assets, which explains why Congress has shown interest.
Fortunately for those about to inherit or bequeath an IRA, no such proposal has gone through – yet. But the conversation offers a useful reminder about the benefits inherited IRAs — particularly the stretch option — can provide in estate planning. And, importantly, the pitfalls you'll want to avoid if you set one up for your heirs or if you're expecting to inherit one yourself.
How stretch IRAs work
As noted above, a stretch IRA is not a product per se; it's a strategy some taxpayers
use to manage assets they want to pass down to their heirs. Before 2006, spouses
were the only heirs eligible for the special tax treatment associated with stretch
IRAs. But the Pension Protection Act of 2006 opened the door for nonspouse heirs
to have the same benefit. For the sake of our discussion, let's focus on nonspouse
beneficiaries and assume they're human rather than charities, estates or trusts.
A conversation about a stretch IRA starts with the broader topic of inherited IRAs.
Here's how it works: When an IRA account owner dies, the account passes to the
designated primary beneficiary, who has two options:
1. "Disclaim" the assets by transferring them to the secondary, or contingent,
beneficiary (assuming there is one).
2. Inherit the assets.
Option 1: If the primary beneficiary chooses to disclaim the assets, he inherits nothing and all the assets pass
to the contingent beneficiary, who can then set up a distribution schedule based on his own life expectancy. The benefit to this method is that the
contingent beneficiary could be a child or grandchild whose life expectancy is much longer than that of the primary beneficiary, and who therefore has a much longer time period over which to stretch the required minimum distributions (RMDs). RMDs are basically calculated by dividing the account total by the number of years the heir is expected to live, a number provided by an IRS life-expectancy formula.1 That means RMDs are much smaller when an heir is young, giving the account time to compound and grow over the lifetime of that heir.
If the primary heir chooses to inherit the assets, he must take specific steps. Commingling the assets with his own IRA or other accounts is not allowed; instead, he must "retitle" the account as an inherited IRA in the name of the deceased owner, typically something like this:
Name of trustee or custodian
IRA John Doe deceased
For benefit of (FBO) Mary Doe
Note that if several beneficiaries inherit assets, they could each open an IRA account in the name of
the deceased, "FBO" their own names. Or they could choose to keep all heirs on one account, and their
distribution schedule would then be based on the age of the oldest heir.
After retitling the account, the beneficiary has three distribution choices:
1. Take the entire sum all at once and pay taxes on it in that tax cycle.
This option could bump the
beneficiary into a higher tax bracket, so more of the assets will go in the tax till.
2. Take any amount at any time but completely liquidate the account within five years.
With this option, the
heir would pay taxes on distributions in the year they were taken.
3. Take RMDs based on the beneficiary's age.
This option stretches the IRA distributions across the lifetime
of the beneficiary.
Now let's discuss mistakes you'll want to avoid.
Three common inherited IRA mistakes
It's best to work with professionals because properly setting up inherited IRAs to allow for the stretch option
is crucial. Mistakes are common — and potentially costly. Here are three:
1. Failing to name primary and contingent beneficiaries. It's imperative to name beneficiaries on the
beneficiary form that's kept on file with the institution that manages the IRA. Actually, before naming
beneficiaries, the first step is to ensure the institution allows for stretch IRAs — sometimes called
multigenerational or legacy IRAs. If it doesn't, an IRA can be transferred to a firm that does allow this
option. But in many cases, it's just a matter of telling the firm what you're trying to achieve and getting
written confirmation that the firm can accommodate stretch IRAs. Choosing beneficiaries is the next
step. The consequences of not having a beneficiary named can be severe, including full liquidation — and
payment of all associated taxes! — within a year of the original account owner's death. (Note that in most
cases, a will doesn't cover these accounts. The beneficiary form determines who inherits the IRA.) Be sure
to name both primary and contingent beneficiaries, in case your primary wants to disclaim the account
and allow it to pass directly to the contingent beneficiary. Important: Contingent beneficiaries cannot be
added once the original account owner dies.
2. Missing key deadlines. It's critical that the funds are transferred into a properly titled account by Dec.
31 of the year following the year the original account owner dies. If the account is inadvertently set up
in the name of a nonspouse beneficiary (instead of the FBO method noted above), the IRA would be
distributable, making the funds immediately taxable and potentially creating a large tax bill for the heir.
If a properly titled account is set up after the deadline, the stretch IRA option is lost, and the funds will
have to be paid out according to the five-year rule.
3. Failing to take RMDs. The rules about taking RMDs for nonspouse IRA heirs are, not surprisingly, complex.
– First, if the original IRA owner dies after age 70½, his RMD must be taken by the heir for the year of the
owner's death and cannot be included as part of the inherited IRA assets.
– Second, if the beneficiary forgets to take an RMD, the stretch benefit could be lost and the five-year rule
could kick in, requiring the entire balance to be paid out within five years.
– Third, failing to take the appropriate RMD may result in a 50% tax on the portion of the RMD not taken.
Note that although Roth IRA account holders aren't subject to RMDs, heirs of Roth IRA accounts are.
Making the most of an inherited IRA
All technicalities aside, inherited IRAs and the stretch option are useful tools for estate planning. And there
are benefits beyond the stretch option:
- While heirs of traditional IRAs must pay income taxes on the distributions, as discussed above, the assets
that remain in the account are allowed to accumulate tax free.
- The heir to a Roth IRA, like the original owner of the account, never owes income taxes on any of the
distributions as long as the account has been open at least five years before the first one is taken.
To play around with the stretch concept, visit javacalc.com/java/StretchIRA.html, where you'll find an
RMD and stretch IRA calculator. But before you take steps to set your account up as a stretch, remember:
Inherited IRAs are complex. To make the most of yours, work with a financial advisor, accountant or estate
attorney to explore all the legal and financial considerations. Only then can you rest assured that your
intentions — or those of the person who named you as a lucky beneficiary — are fulfilled.
Note that stretch IRA illustrations typically rely on several assumptions, such as tax laws don't change;
inflation isn't a factor; and the IRA's underlying investments will grow at a constant, predictable rate. These
assumptions may or may not affect the account assets. Talk with your tax expert about this strategy to
ensure you thoroughly understand it.