(Forbes) -- Will you leave a legacy for your heirs, or a tax burden? You may be unknowingly leaving the lion’s share of your life savings to your least favorite relative, Uncle Sam.
We cannot possibly cover the entire scope of this discussion in a single article, but “stretch IRA” should at least be in your vocabulary. After 37 years in the business, here are the five most common discussions I’ve had with clients. One way you can strategize for these problems is a lesser-known technique called the stretch IRA. I fear I will run out of money before I die.
I have a beneficiary who is terrible with money, and the thought of leaving them a lump sum is not appealing.
I have other assets and do not really need to use my qualified accounts to fund my retirement.
How can I lower the taxes my children will pay when they inherit my IRA or 401(k)?
How can I leave a lasting legacy?
The Stretch IRA Strategy
In a nutshell, the stretch IRA is a simple strategy that your heirs can use to help preserve inherited retirement assets by maintaining the account’s tax-deferred status for as long as possible.
The stretch IRA strategy can allow the account owner to spread out the taxes across multiple generations, thereby greatly enhancing your IRA’s potential value.
If the stretch strategy is chosen, a younger beneficiary, who perhaps is not good with money, could receive payments for their life expectancy, rather than a lump sum.
The stretch IRA strategy cannot be implemented by a charity or trust, since the rules require the beneficiary to have a life expectancy.
This might only be an option for those individuals who have other sources of income and prefer not to use their qualified funds because of the additional taxes associated with these types of accounts.
It may also be a good option if there is money left over after your death and your beneficiary wants to use the stretch for another purpose, such as those listed above.
Required Minimum Distributions (RMDs)
In 1987, the IRS instituted RMD requirements to force people to withdraw money from their retirement accounts.
These distributions must begin no later than April 1 of the year after you turn age 70 ½, and the amount you will be required to take changes each year along with your age and life expectancy. Because of the taxes associated with qualified accounts, some people who have other assets they can use during retirement will only use qualified money as a last resort.
Maintaining the Integrity
Because you can’t just do nothing, why not do the next best thing? Consider the stretch option by taking just the RMDs and letting the rest of the account grow tax-deferred. If given the option of paying the taxes now or later, depending on your specific situation, later could be the better choice.
One of the most common mistakes I see people make is taking lump-sum distributions, which forces a lot of unnecessary taxes now and, of course, a far smaller overall inheritance for beneficiaries in the future. If you have a choice between paying the taxes now or paying the taxes later, consider letting the money grow tax-deferred, thereby maximizing the inheritance.
Should I use my IRA or 401(k) account?
The short answer: Not if you don’t have to. Since these accounts (with the exception of the Roth IRA) have been funded with pre-tax dollars, their distributions will most likely be taxed as ordinary income, potentially increasing your tax bracket. It would be wonderful if you could just let your account continue to sit there and grow tax-deferred as it has for many years, but, unfortunately, it’s not quite that simple. At some point, Uncle Sam will force you to begin taking payments.
Will you run out of money with a stretch IRA?
I want to say no, for reasons you will soon find out, but instead I’ll say it would be extremely unlikely you’d run out of money before your life expectancy. First, let’s look at how RMDs are calculated. There are three different life expectancy tables used: the Uniform Lifetime Table, which is used (in most cases) by the original IRA holder to calculate RMDs; the Joint Life and Last Survivor Table, which is used if you’ve named your spouse as beneficiary and they are more than 10 years younger than you; and the Single Life Table, which is used by other beneficiaries who inherit the account.
Now look at any actuarial table and compare it to the Uniform table and you’ll see that the Uniform table doesn’t actually show life expectancy compared to any other actuarial table.
For example, if you look at the Social Security table, in 2015 a man age 70 has a life expectancy of 14.3 years, a female 16.44 years, while the Uniform Table shows 27.4 years. At age 80, the Social Security table shows 8.24 years for a male and 9.63 years for a female, while the Uniform Table shows 18.7 years. So the RMDs are actually calculated over a longer period of time than the life expectancy of the IRA owner, and this doesn’t even take into consideration any potential investment returns.
Note: If potential losses and the longevity of the RMD payouts are a concern, the following is worth mentioning: Although an annuity does not have to be used to implement a stretch IRA strategy, using a fixed or indexed annuity may be a smart consideration because of the principle protection and contractual guarantees associated with these two types of annuities. So if you’re going to do a stretch and are worried about your money running out before you do, utilizing an annuity that guarantees your principal and interest earnings may be an appealing option.
An FYI About Disclaiming
Disclaiming or disinheriting can be a very useful tool, and although it does not have to be a part of the normal stretch strategy, many people have found this information to be very helpful.
An heir may disclaim all or part of their inheritance for any reason. Perhaps they have a large income or estate, and do not need the money. They may choose to disclaim all or part of their inheritance to a child for future educational costs, or for any other reason, which would allow the child to pay taxes each year during their education at their income tax rate, not the parents’ rate. Note: Disclaiming all or part of your inheritance can only work if the decedent's estate plan specified that if the original heir dies before the decedent, the inheritance would go to (in this example) the heir’s children, but this stipulation would apply to anyone the disclaimed money will go to. Additionally, the choice to disclaim must be made by the beneficiaries within nine months of the account holder’s death. For more information on disclaiming inherited retirement plans, please click here.
Stretch it? Wrap it up; I’ll take it!
So in summary, let’s take a look at a scenario that includes a married couple and their children and grandchildren.
The original IRA account holder would begin taking RMDs once they reach 70 ½ until they pass, then their spouse will inherit anything remaining in the IRA and continue RMDs based on their life expectancy.
After both the original account holder and their spouse pass, any remaining funds would pass to the children and/or grandchildren. Rather than being forced to take the traditional lump-sum distribution and pay taxes, the stretch IRA technique allows the beneficiaries to take payments (RMDs) based on their own life expectancy, just like Mom and Dad did. How much of a difference that might make depends on the ages of the heirs, but because of the continued tax deferral, it usually means a far greater inheritance as compared to the lump-sum method.
Using this technique can allow even a modest IRA, 401(k), 403(b), or any other qualified account to grow into a much larger inheritance, again, because of its continued tax-deferral. The kicker: The account should transfer into an inherited IRA, usually with the decedents and beneficiaries. So this means that your children and or grandchildren will get a check with both, yours and their, name on it each year for potentially the rest of their lives – now that’s what I call a lasting legacy!
Note: Not all IRA custodians will allow the stretch IRA. Having a well versed financial and tax professional is important for its proper implementation.
A Final Word:
The IRS provides taxpayer information for beneficiaries of inherited IRAs. The rules related to inherited and stretch IRAs are complicated, and neglecting to take RMDs can have financial consequences. For these reasons, and the complexity of other concepts shared in this article, you may want to consult a tax professional for additional information and implementation.