Think about affluent clients with estates subject to estate taxes. Do they hold significant assets in individual retirement accounts or qualified retirement plan accounts? Do they intend to transfer these accounts to children and grandchildren? Do they recognize the erosion attributed to estate and income taxes?
For this discussion, the affluent refers to people whose estate size would subject their estate to federal estate taxes upon death. They are business owners and highly compensated executives and consultants who have found qualified retirement plans to be an effective means for accumulating assets in the working years. As a practical matter, many have no need or intention to tap into those assets in retirement. Instead, frequently, they intend to pass these assets on to their children and grandchildren.
When IRA and other qualified plan assets are incorporated into the family estate plan, a so-called “stretch IRA” strategy is typically explored. The goal: to keep the qualified assets income tax deferred as long as possible.
However, this must be done with care, so that the plan accomplishes its purpose.
In the traditional stretch IRA:
o The account owner only takes withdrawals when forced to by tax law–as “required minimum distributions” (RMDs)
o At the death of the account owner, her spouse takes the IRA as his own and re-establishes the RMD amounts and timetable.
o Upon death of the surviving spouse, the IRA is passed onto the children as an “inherited IRA” and the RMDs are reset based on age of the oldest beneficiary.
o At the death of a child, their children (the grandchildren of the original account holder) take the remainder based on the RMD timetable established for their parents.
That sounds simple enough. But, there is more to it.
Although typical stretch arrangements do provide withdrawal flexibility for future generations and provide potential tax deferral, they generally fail to address the erosion of values due to taxes and the timing of distributions. Therefore, it’s important to recognize that stretch IRAs have built-in disadvantages.
Some examples include:
–All withdrawals are subject to income tax to the recipient (2008 federal maximum 35%).
–Account values are included in the estate of each succeeding generation and may be taxed in more than one generation (2008 federal maximum 45%).
–RMDs will reduce account values and trigger income tax as received.
–Each succeeding account beneficiary only gets what is left by the prior beneficiary, which could be nothing.
–The grandchildren may have to wait an inordinate amount of time to benefit from their grandparent’s IRA account
Review the example of tax erosion on a $1 million stretch IRA in Table 1. Then consider this: For all IRA and qualified plan account holders, income taxes will diminish what is left for retirement and heirs. However, for the affluent, tax erosion poses a more significant threat especially to values left to heirs.