The Concept of stretching out an IRA to beneficiaries is often not addressed in the financial services community. When one sees how the IRA is taxed to beneficiaries as ordinary income, you can see how this can be a very significant tax that the IRA owner may have never really considered. For this discussion, we will assume that a person has rolled over their existing 401k’s or 403b’s to IRA.
If a spouse dies first, the remaining spouse can simply elect a spousal continuation, and take over the existing IRA’s with no tax consequence. But what happens when both parents die and the kids are now in line to receive the funds? Because this money has never been taxed, every dollar of the IRA is taxable to the beneficiaries.
Unfortunately, the majority of IRA’s are taken as a lump sum by the beneficiaries, and it is taxed to them as ordinary income in the year that they receive it!! Usually the beneficiaries are still employed, with many at the peak of their earning years, so they are already in higher tax brackets. When the beneficiary has to claim the inherited IRA amount in addition to their earned income, it can cause the inherited IRA to be taxed at levels well above 25%, usually nearing 30 to 40%, depending upon state and federal taxes.
When the IRA owner sees the possibility of their hard-earned money losing such a significant amount in taxes at distribution, it is very disheartening. The majority of IRA owners don’t realize this, and for many this fact is a real eye opener! Also for many IRA owners they don’t want to see their kids or grandkids spend all the money at once, when it could be used to help them with their retirement.
The Stretch IRA to the Rescue
Fortunately, in the tax code, there is another option available, which is known as the Inherited IRA, also known as the Stretch or Multi-Generational IRA.
If planned properly, an IRA can become one of the greatest family wealth building opportunities under the current tax laws. A beneficiary can keep the account as in “Inherited IRA” and allow the account to stay intact and still retain its tax deferred status. An Inherited IRA or Stretch IRA has a much lower minimum distribution table. With a reasonable growth rate within the account the account may not start to be depleted until one is in their 80’s.
So, if someone is in their 40’s when they inherit an IRA they can stretch the account out for 40 or more years and for grandchildren the account may grow for over 70 years! By being able to compound the account without paying taxes the results can truly be amazing and therefor it is one of the most powerful family wealth vehicles available today!
So this sounds really good in concept but unfortunately many IRA accounts are depleted very quickly because of poor planning and not avoiding the many pitfalls that can destroy a plan.