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Inheriting an IRA? It Pays to “Stretch” It

What happens to an IRA when it is inherited by the account owner’s children?

Myth: The account is gobbled up in a combination of estate taxes and income tax.

Reality: Under present regulations that allow for a $5 million exemption from estate taxes for both husband and wife ($10 million total), very few IRAs will be affected by estate taxes.

If the person who inherits the IRA chooses to take a total distribution immediately and pay all the income tax in one year, that would take a large bite (of course, a Roth IRA would not incur this tax). A solution is to have the beneficiary take advantage of what the regulations allow and stretch the life of the account as long as possible as an IRA. Depending on the individual’s financial need, this may be advantageous for both the Traditional IRA and Roth IRA.

When an IRA is inherited, the requirement is to start taking a minimum distribution the year following the original account owner’s death, based on the child’s life expectancy. Hence a “stretch” IRA. The Traditional IRA continues to grow tax-deferred, and the beneficiary pays income tax only on the amount withdrawn. If it is a Roth IRA, growth and withdrawals are tax-free.

Let’s take an example of the IRA owner who died at age 85 and his daughter inherited the IRA at age 55 and is able to start taking the distribution the following year. Life expectancy for a 56-year-old is 28.7 years, according to the government table used for the calculation. To put it another way, the life of the IRA is stretched for approximately 29 years.

The year of death, the IRA owner’s required distribution is 6.75% of the previous year-end account value ($500,000 in this example), or $33,750. The daughter’s first required distribution the next year is 3.5% (100/28.7) of the previous year-end value, or $17,200. (Numbers have been rounded slightly for ease of understanding.) As you can see, the required distribution is considerably lower for the daughter. Each year the minimum required distribution percentage goes up slowly, based on the life expectancy number counting down by one each year.

If we assume a 6% rate of return, the account would grow for 11 years before the withdrawals are greater than the earnings. The daughter would receive approximately $1.2 million in distributions over the 29-year life of the account, instead of $500,000 in one immediate payment at the time of her father’s death. This amount could be higher or lower, depending on actual returns and timing of returns.

It is important that the child or children be clearly listed as beneficiaries. Each child would get their own beneficiary IRA after death of the original owner. This is important because each child uses his or her age to determine required distributions. If specific beneficiaries are not named, this would force the money to be paid out on an accelerated basis with possible negative tax consequences.

What questions do you have about investing, inheritance and estate planning?

 

Source:  IRS Publication 590, Individual Retirement Arrangements (IRAs) 2010 Returns.  Feb. 2011

For illustrative purposes only, not indicative of any specific investment strategy.

Stretch IRA’s are only appropriate for investors that will not need the money to fund their retirement. Investors should be aware that changes in tax laws and IRS Rules may adversely impact the use of the stretch IRA strategy. Typically, strategies that involve the use of stretch IRAs assume that investors take only the smallest amount from the stretch IRA as required by the current tax laws beginning at age 70 1/2. Please consult your tax adviser to determine what impact, if any, the above information may have on your tax situation for the current tax year or in future years.

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Posted in Financial Education, Reaching Retirement.

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