Consider your "estate" for a moment--what's in your estate? Chances are, there is a significant IRA or retirement account in your estate. Yet, most people fail to do proper planning for IRAs in their estate plan. In fact, your Last Will & Testament does not control your IRA.
I hope you use this short Q&A on Inheriting an IRA to evaluate your estate plan and make changes as needed:
1. What’s the problem with my IRA passing through my will or estate? The short answer is that you never want your IRA to pass via your will, because it’ll force your beneficiaries to take a lump sum distribution and pay Uncle Sam all income taxes immediately. Instead, you should designate your IRA directly to beneficiaries or to a special IRA trust to take advantage of the “stretch IRA” tax-shelter opportunities.
2. What is a “Stretch IRA”? A Stretch IRA is also known as an Inherited IRA, Beneficiary IRA or Multi-generational IRA. The “stretch” lets your beneficiary continue the tax-deferred treatment of your IRA during his/her 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 tax rate right now is 39.6%).
3. Do I Need an IRA Trust? For significant IRA’s (i.e., $150,000 or more per beneficiary), it makes sense to protect the IRA inside an IRA Trust. The three major benefits of an IRA trust are (1) ensuring the “stretch” is taken, (2) protecting the IRA from the creditors of a beneficiary, and (3) keeping the IRA in your bloodlines. An IRA Trust is a special trust and costs more to design. However, your legacy and the benefits for your family greatly outweigh any cost of an estate plan.
4. Why does a “stretch” make more sense than a lump sum distribution? A lump sum distribution of an IRA will trigger all of the income taxes to be paid immediately. For instance, on a $200,000 IRA at a 25% tax rate, the beneficiary will be left with $150,000. Even worse, the remaining funds are no longer tax-deferred, but rather subject to ordinary income and capital gains taxes. In other words, that lump sum may be whittled down rather quickly. By contrast, a $200,000 stretch IRA may be worth over $1.5 million over a beneficiary’s lifetime, depending on age and how the IRA is invested. The reason? A younger beneficiary can let the funds sit in the IRA tax-deferred account longer, meaning Uncle Sam can’t eat away at it.
5. Can my beneficiary simply roll-over my IRA into their own IRA? No, only your spouse can do that. Any other beneficiary cannot do a roll-over. The either must take a lump sum, or take a Beneficiary IRA. Or, you could establish a trust so that the IRA is held for them in trust.
6. What do most beneficiaries decide to do when they find out they’re inheriting an IRA? Most beneficiaries opt to take a lump sum, which Uncle Sam appreciates. The custodians of IRA accounts are typically unhelpful to the beneficiaries in making this important decision. A beneficiary only has one chance to get it right. An IRA Trust can be helpful because it will prevent the lump sum distribution, and force the beneficiary to take the Beneficiary IRA (Remember, another term for “stretch”). Ask yourself this… before reading this article, how much knowledge did you have about Stretch IRAs? Consider that your beneficiaries will probably know less than you and not understand the decision they make.
7. My IRA is for my retirement, so why should I be worried about who inherits it? People that believe they will spend down their IRAs in retirement often forget two concepts: First, they were and are savers, and that habit won’t change overnight. Second, they will only take their required minimum distribution because they don’t want to pay Uncle Sam one penny more than they have to. Most people will leave significant IRAs if they were savers during their lifetime, so it’s best to plan for the strong possibility that your heirs will inherit your IRA.