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’s.
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 Stretch or Multi-generational IRA. This allows the named beneficiary after the remaining spouse, to continue the tax deferral of the IRA over their remaining life expectancy. This keeps the account intact, and the beneficiary does have to take a small amount out each year. When you look at the larger amount of wealth that is preserved over a beneficiaries’ lifetime, you can see just how important this is in one’s overall estate plan.
The Key to the Kingdom
The problem that still exists, however, is how are you going to make sure the beneficiary makes the proper elections, and will the existing custodian assist the beneficiary in this? Unfortunately when a parent passes, the person who is in charge of handling all of the affairs, has a lot of paperwork, including the filing of death certificates with numerous cumbersome forms to fill out, which can be very overwhelming, and confusing. Often there are multiple custodians and most of the time the beneficiaries may never even realize their choices as beneficiaries of an IRA.
Setting It up Ahead of Time
A good estate plan is one where all of the contingency plans are accounted for so that nothing unexpected, such as taxes or legal proceedings, can erode the value of a person’ estate. This couldn’t be more true with IRA planning. So what can an IRA owner do ahead of time to be sure the stretch IRA happens at their passing?
Two Ways To Be Sure
In order to insure that the IRA funds are not paid out as a lump sum to the remaining beneficiaries, and that the funds can be effectively stretched out to their heirs, is either by using an IRA Inheritance Trust, or by using a Restricted Beneficiary Form, that has been developed by insurance companies for annuities owners.
IRA Inheritance Trust
This is a relatively new trust development that is separate to the Revocable Living Trust, which allows the trust to be the beneficiary and still provides the stretch option. This is something that a traditional Revocable Living Trust is not set up to do. It is a very effective estate planning tool, although it is fairly expensive to set up, and not a lot of estate planning attorneys offer them.
Using An Annuity With a Restricted Beneficiary Form
Since Insurance companies have been in the business of distributing wealth for many years, they have realized a perfect niche opportunity, and some have developed the Restricted Beneficiary Form. IT is important to point out that not ALL companies have this as an option, so it is very important to know this before choosing an annuity to use for the IRA.
Just what does this form do? If an IRA owner uses an annuity with a company that has this as an option, then this form can allow the owner of the IRA to set it up so that it will automatically stretch the IRA to the remaining beneficiaries.
How Does This Work?
Many of the Restricted Beneficiary Forms will allow a number of choices; restricted, partially restricted, and non-restricted.
- Restricted means that the IRA beneficiary cannot take any other choice but the stretch option. This can be very effective for children or grandchildren with spendthrift issues, or to just make sure the most tax advantaged strategy is implemented.
- Partially restricted allows some of the IRA to be paid out as a lump sum, with the remaining amount being stretched out.
- Non-restricted still has the IRA to be set up as a stretch, but if the IRA beneficiary wishes they can override the stretch option and take it as a lump sum.
Why an Indexed Annuity Can Be a Perfect Choice for IRA’s
- It provides a safe investment with growth potential, for a portion of a portfolio that suites the majority of retirees who are Moderately Conservative. Having stock market exposure from 30 to 40% of a portfolio, falls within a Moderately Conservative mix, since most retirees don’t want to see a drop of more than 10% in their portfolios. Using an Indexed Annuity for a portion of the remaining amount of a portfolio out of the stock market, makes perfect sense when setting up your asset allocation.
- An Index Annuity for an IRA stabilizes a portfolio during the RMD or withdrawal phase. There is nothing that will cause a portfolio to go down quicker than having to take funds out of a portfolio if it is decreasing due to market declines.
- By consolidating existing IRA’s into an Index Annuity with a Restricted Beneficiary Form, it can allow the IRA owner to also set up the IRA to be the most tax efficient at distribution and make sure it doesn’t get destroyed with the impact of taxes when not properly planned for.
Setting up your IRA’s to take advantage of the Stretch or Multi-Generational option should be part of an effective estate and financial plan to maximize and preserve a person’s assets. Most people have not addressed this issue and unfortunately will see large amounts of their portfolio nest egg that they worked so hard to maintain and grow over their lifetimes be eroded very quickly in taxes. Don’t let this happen to you! For more information on IRA Inheritance Trusts or using annuity Restricted Beneficiary Forms, send us an email and we would be glad to help you fix this problem!