BREATHE NEW LIFE INTO A TRADITIONAL IRA
Careful planning can provide continued tax-deferred growth for your beneficiaries
As the name "individual retirement account" (IRA) suggests, the primary purpose of an IRA is to save for retirement. But IRAs - which often accumulate enormous amounts of wealth - can also be a significant part of the legacy you leave to future generations.
Unfortunately, that legacy may be burdened with a huge tax liability if your IRA is a traditional one, not a Roth. With careful planning, however, you and your heirs can stretch a traditional IRAs tax-deferred growth for years or even decades while minimizing the tax impact.
Tax Considerations
Inherited IRAs are treated differently than other assets. For example, if you leave appreciated stock or real estate to a loved one, he or she receives a "stepped-up basis" in the asset. In other words, your heir's cost basis is equal to the asset's fair market value on the date of your death. If he or she immediately sells the asset, no taxable gain will be recognized, even if the asset's value has appreciated significantly since you acquired it.
But there is no stepped-up basis with an IRA. Instead distributions to your heirs are taxable at their ordinary income tax rates, as high as 35%. And with estate tax rates currently topping out at 46%, taxes can quickly consume a substantial portion of your nest egg.
One way to avoid this problem - especially if. our estate plan includes charitable donations - is to name a charity as the beneficiary of your IRA and bequest other assets to your loved ones. As a tax-exempt entity, the charity pays no taxes on the gift, and your heirs enjoy a stepped-up basis in the non-IRA assets they receive.
REQUIRED DISTRIBUTIONS
Once you reach age 59%, you can withdraw as much as you want from your IRA without penalty. Although you'll still have to pay income taxes on your withdrawals, there will be no penalty. The key to maximizing an IRA's benefits is to leave the funds in the account, growing tax-deferred, for as long as possible. But by April 1 of the year following the year you reach age 70% (the "required beginning date"), you have to start taking annual required minimum distributions (RMDs). The penalty for failing to take an RMD is severe: 50% of the amount you should have withdrawn.
To calculate the RMD for a given year, divide your IRA balance by the distribution period provided by the appropriate IRS life expectancy table. For example, if you're 70 years old and your account balance is $1 million, your distribution period is 27.4 years under the Uniform Lifetime Table. So your RMD is $36,496 ($1 million / 27.4).
If your sole beneficiary is your spouse and he or she is more than 10 years younger than you, however, your distribution period is based on the Joint Life and Last Survivor Expectancy Table. Let's say your spouse is age 55. Your distribution period would be 31.1 years, for an RMD of $32,154.
NAMING A BENEFICIARY
You can name anyone as beneficiary of your IRA including your spouse, children, grandchildren, friends, trusts and charities. The point is to name someone, because dying without a designated beneficiary could be problematic for your loved ones.
For example, if you've already started taking RMDs and pass away without having named a beneficiary, your heirs must take distributions based on your remaining life expectancy at the time of your death. If you haven't reached your required beginning date, your heirs must withdraw the entire account balance, subject to ordinary income taxes, within five years.
By designating one or more beneficiaries, you enable your heirs to stretch distributions over their own life expectancies, spreading the taxes over many years and allowing the IRA to continue growing tax-deferred for as long as possible. To avoid negative tax consequences, name a primary beneficiary and one or more contingent beneficiaries.
LEAVING IT TO YOUR SPOUSE
Passing your IRA to your spouse is a logical choice and gives him or her three options:
1. Take all of the funds and pay income tax on the withdrawal,
2. Leave the IRA in your name, or
3. Roll the funds over into a new or existing IRA in his or her name.
Let's suppose your spouse is under age 59% and needs the funds for living expenses. What should he or she do? It's probably best to leave the IRA in your name. That way, your spouse can take money out without paying a 10% early withdrawal penalty.
If your spouse is older than age 59 1/2 or doesn't need the money right away, it's preferable to roll the funds into an IRA in his or her name. This way, your spouse can name new beneficiaries and defer RMDs until he or she reaches age 70 1/2.
But if you're not sure whether your spouse will need the money in your IRA, play it safe by naming him or her as your primary beneficiary and your children or other heirs as contingent beneficiaries. After your death, if your spouse has sufficient funds to live on, he or she can disclaim the IRA assets, allowing them to pass to your contingent beneficiaries.
Covering All The Bases
To preserve the life of your IRA, review your documentation to be sure you've designated beneficiaries and talk to your family about their options for dealing with an inherited IRA - so, when the time comes, a tax advisor can help them choose the best course of action.
Bequesting An IRA To Nonspousal Beneficiaries
Nonspousal beneficiaries can't roll an inherited traditional IRA into one of their own. But they can prolong the IRA's life for years by stretching required distributions over their own life expectancies. Typically, this is done by establishing a special IRA that remains in your name but is "for the benefit of" your heir. These accounts go by a number of different names, including stretch IRA, legacy IRA, dynasty IRA and inherited IRA beneficiary distribution account.
If you name multiple nonspouse beneficiaries, they can split the IRA into separate accounts. This allows each child, for example, to take distributions based on his or her own life expectancy. If they don't split the IRA, minimum withdrawals will be based on the oldest beneficiary's life expectancy, and the funds will be distributed more quickly. |
