Dangers of Inherited IRAs, Part 1

If you are like most folks these days, you have a significant portion of your estate saved in retirement accounts (IRA, 401(k), 403(b), TSP, etc).  Retirement accounts are a great legacy planning tool because they offer the ability for your beneficiaries to continue the tax-deferred treatment (e.g. “Stretch IRA”).  Unfortunately, many beneficiaries make mistakes and instead take a lump sum distribution. There is nothing you can do within a traditional will to prevent that from happening. 

In short, there are tremendous opportunities for your heirs, but also a minefield ahead. Here are a few points to consider about inherited IRAs:

1. Can My IRA Pass Through A Traditional Will?

Short answer?  Yes, but you don’t want it to.  When your IRA is passed through your will, it forces your beneficiaries to take a lump sum distribution and pay Uncle Sam all income taxes immediately.  In the alternative, you should designate your IRA directly to beneficiaries or to a special IRA trust to take advantage of the tax-shelter opportunities.

2. Explain the “Stretch IRA” Concept: 

What people call a Stretch IRA is also known as an Inherited IRA, Beneficiary IRA or Multi-generational IRA.  Basically, you’re “stretching” the tax-deferred treatment of your IRA to your beneficiaries during their lifetime.  With a stretch, the beneficiary takes small distributions annually, allowing the remainder of the funds to continue growing tax-deferred.  This can lead to big gains over the years and provide benefits for multiple generations.  In contrast, a lump sum distribution would mean Uncle Sam getting a big cut of your estate (the highest income tax bracket is currently 39.6%… OUCH!).

3. What is an IRA Protection Trust?

For significant IRA’s (i.e., $150,000 or more per beneficiary), it makes sense to protect the IRA inside an IRA Protection Trust.  If you’re unfamiliar with trusts, the quick definition is that they are a legal document between three (or more parties).  The first party cedes control of a property or properties to a second party, with the second party directed to act as a fiduciary for a third party. 

 

An IRA Protection Trust does three things for your retirement accounts: (1) Ensures the “Stretch IRA” benefit is not squandered, (2) Provides Asset Protection for your IRA (protects from divorce, creditors, lawsuit, bankruptcy, spendthrifts, etc.), and (3) Ensures your IRA stays in your bloodlines.

 

If this Q&A raises questions of your own, be sure to read next week’s continuation, where we’ll answer four more questions.  Or, if you have questions related to your own estate and retirement accounts, give me a call at 215-706-0200 to set up a time for us to meet and find the answers you need.