With Individual Retirement Accounts (“IRAs”) among the largest investment assets left to heirs, deciding what to do with an inherited IRA is one of the most important decisions facing many account owners. Inheriting a traditional IRA provides a unique opportunity to continue tax-deferred investing. Over time, that tax advantage can dramatically increase the value of the inheritance.
IRA account owners have the ability to name primary, secondary and even tertiary beneficiaries who they wish to receive their IRA upon their death. This strategy allows the IRA to be without going through the probate process. If no individual is named as beneficiary, the deceased estate becomes the beneficiary and the IRA must now pass through probate and be distributed according to the deceased person’s will. Under this scenario, the person inheriting the IRA must take distribution and pay ordinary income taxes on all of the IRA proceeds within 5 years from the date of death of the original owner. This is a mistake you want to avoid in order to preserve the substantial tax benefits of long-term tax deferral. A strategy that my firm has coined the, “Super-Super Stretch IRA”, gives your heirs the option of determining where best to place your IRA account for maximum benefit after your death.
Typically, an IRA account owner will name his or her spouse as the primary beneficiary and children as contingent beneficiaries. A spousal beneficiary has the following choices:
Roll over the account into an existing or new IRA accounts. The surviving spouse must begin taking Required Minimum Distributions (RMD) at age 70 ½.
Remain a beneficiary by transferring the IRA to an Inherited IRA account. The deceased person’s and the beneficiary’s names both remain on the account. This can be advantageous if the surviving spouse is younger than age 59 ½ and wishes to draw funds from the IRA without paying a 10% early withdrawal penalty.
Cash out the account and pay ordinary income tax on the distribution. This is typically not a wise income tax decision.
Disclaim the IRA. If the surviving spouse has sufficient assets, he or she might choose to disclaim a portion or all of the IRA in favor of the contingent beneficiary(s). Here’s where the Super-Super Stretch IRA comes into play. Let’s look into this option further.
First, non-spousal beneficiaries must begin taking RMDs by December 31st of the year following the year of death of the original IRA owner. RMDs are based on life expectancy so the younger you are the smaller the required distribution. Therein lies a potential financial advantage. Let’s assume a 68-year-old owner of a $500,000 IRA account passes away. He named his 65-year-old wife as primary beneficiary, his 40-year-old son as secondary beneficiary, and his 5-year-old granddaughter as tertiary beneficiary. Let’s further assume that neither the wife nor the son needs the IRA account.
If the wife decides to do an IRA rollover, she will be required to take minimum distributions based on her life expectancy beginning at her age 70 ½. If she disclaimed her interest in the IRA, the son would become the beneficiary. If he in turn disclaimed his interest in the IRA, the granddaughter would become the beneficiary. The granddaughter would then take distributions over her life expectancy, which would allow for a much longer period for tax-deferred growth.
Let’s look at the potential impact of allowing the grandchild to inherit the $500,000 IRA. Assuming an 8% annualized return before taxes; a 35% income tax rate; and reinvestment of all distributions, the money would grow to almost $30 million by the time the granddaughter reaches age 65! Not only is the accumulation effect much greater under this strategy, but estate taxes have been postponed for more than sixty years. In order to take advantage of this strategy, correct handling of your beneficiary designations is vital and should be reviewed with your professional advisor in conjunction with your overall estate plan.
My thanks to my partner, Hugh Smith, CPA for his assistance with this article.