The shift from company-provided pensions to self-funded retirement plans has created a unique estate planning problem. When people retired with pensions, there was little estate planning necessary because the pension died with you. Today, people accumulating large pre-tax balances for retirement in their IRAs and 401(k)s may be hit with both estate taxes and income taxes, which combined can consume as much as 80% of these accounts. One of the best ways to mitigate the income tax bite is to ensure your heirs will be able to stretch out required minimum distributions as long as possible.
The Advantage of the Stretch
Let’s look at an example that appeared in the October 2005 issue of Investment Advisor Magazine. Mom passes away at age 80 with an IRA worth $540,000. Son, age 45, earns 8% annual growth on the account and takes only the required minimum distributions based on his life expectancy. By the time he is age 80, he will have taken out about $2.9 million from the IRA. On the son’s passing, there will still be $700,000 remaining in the IRA to pass down to the next generation. That means that because the son used the stretch, mom’s $540,000 IRA was ultimately worth over $3.5 million to her family.
What would have happened if the beneficiary didn’t use the stretch? If the son decided to take all of the money out of the IRA when he was 45, about one third or $1.5 million in future value would have been lost. Many unforeseen or unplanned events in life can cause the dissolution of an IRA. Children get divorced, spend unwisely, or make improper investment decisions. Any of these situations could cause your IRA to fail to deliver the largest benefit to your family.
How to Ensure the Stretch
- Roll funds from your 401(k) and 403(b) plans to IRAs
Most 401(k) and 403(b) plans require non-spouse beneficiaries to distribute all of the funds in the account within five years after the death of the original owner. Therefore, these plans do not allow beneficiaries to use the valuable stretch technique. - Update Your Beneficiary Designations
If you fail to name a living beneficiary or contingent beneficiary, or you name your estate as beneficiary of your IRA, the funds will have to be distributed within five years of death and the stretch will be lost. - Control Distributions with a Trust
Rather than leaving the IRA directly to an individual, you can leave it to an IRA Inheritance Trust. The trustee you name can ensure your beneficiaries use the proper stretch techniques. In addition, when there is more than one beneficiary, each beneficiary can stretch distributions out over his or her own life expectancy, which is a great advantage when there is a significant age difference between your heirs.
There are other advantages to using this type of trust, as well. For example, a trust provides greater protection for your beneficiary against losing the inherited IRA to divorce, lawsuits, or your beneficiary’s own unwise spending habits.
In addition, using a trust allows you to influence how the money will be managed by giving instructions to the trustee. In this way, you can have peace of mind knowing your IRA will be invested in the manner that maximizes your family’s wealth.
Appropriate candidates for this type of planning are people with IRAs worth at least $200,000 and people whose primary beneficiaries will outlive them by 10 to 15 years.
The difference between properly planning for the eventual transfer of your IRA and leaving it up to chance can be millions of dollars to your family. Make sure your estate plan includes strategies to stretch your IRAs as long as possible. The IRA Inheritance Trust is a relatively new estate planning technique. To learn more, call us at 410-461-3900.