The IRS took the unusual step of permitting a taxpayer to undo a lump-sum distribution from an IRA and avoid the 10 percent penalty for early distributions. The taxpayer, a minor, asked the IRS to allow her to fund an inherited IRA with the previously dispersed funds. Surprisingly, the IRS agreed, and permitted the taxpayer to avoid any income tax or penalties associated with the initial distribution.
IRA Stretch Planning
Unfortunately, the IRS does not reach that kind of ruling very often, so it is essential for us to understand the mechanics of stretch IRA planning. Poor planning can obliterate the value of an IRA, reducing the potential gift by 50 percent or more.
The most important point to remember in IRA planning is that, if a nonspouse beneficiary rolls an inherited IRA into an IRA held solely in the beneficiary’s name, the entire amount of the rollover is counted as a distribution and taxed to the beneficiary. Fortunately, there are other options for dealing with inherited IRAs.
In all cases, to avoid being taxed on the inherited account, the IRA should be maintained in the name of the decedent. Then, the timing of required minimum distributions (RMD) from the account will depend on whether there is a “designated beneficiary.”
If there is a designated beneficiary and the taxpayer died before the taxpayer’s required beginning date, then the beneficiary’s RMD is based on the beneficiary’s life expectancy. If there is a designated beneficiary and the taxpayer died after the taxpayer’s required beginning date, then the beneficiary’s RMD is based on the longer of the beneficiary’s life expectancy and the taxpayer’s life expectancy.
Any individual can be named “designated beneficiary” of an IRA, including not only children, but also grandchildren and even great-grandchildren. Estates, charities, and business entities, however, can’t be named as designated beneficiaries.
If there is no designated beneficiary and the taxpayer died before the taxpayer’s required beginning date, then the beneficiary must withdraw all of the retirement account within five years of the taxpayer’s death. If there is no designated beneficiary and the taxpayer died after the taxpayer’s RBD, then the beneficiary’s RMD is based on an IRS table that takes into account the deceased taxpayer’s life expectancy.
The power of stretch IRA planning is obvious when you consider a simple example.
At the time of his death, Father has $250,000 in an IRA. If he dies without the account having a named beneficiary, and the recipient of the account under his will or trust rolls the IRA over into the beneficiary’s personal IRA, the $250,000 will be taxed at 35 percent at the federal level and possibly 7 percent at the state level. (The state component of the tax may vary to as low as zero percent in states without an income tax to as high as 11 percent in Hawaii and Oregon.)
That 42 percent tax will reduce the net gift to the beneficiaries to $145,000. If, on the other hand, Father names his two grandchildren as designated beneficiaries of the account, and after his death the funds in the IRA are split between two inherited IRAs in the name of Father (followed by the word “deceased”) and “for the benefit” of the named beneficiary, the IRA will be allowed to grow over the lifetime of the beneficiary grandchildren.
If the grandchildren are both 5 years old at the time of their grandfather’s death, the IRA funds can grow tax-deferred for as long as 65.5 years before RMDs are required. Compounded annually at a modest 5 percent growth rate and assuming no withdrawals from or additions to the accounts, each beneficiary’s account would grow to $4,275,010 before they are required to take RMDs.
And if the grandfather’s generation-skipping transfer tax-exemption and gift tax exemption amounts are properly allocated to the transfer, no transfer tax will be paid on the gifts.
Stretch IRA planning is powerful because it allows tax-deferred accumulation in the IRA, not only over the original account owner’s lifetime, but also over the lifetimes of direct beneficiaries and beneficiaries even further down the chain.
But the beauty of inherited IRAs stretches beyond taxes. Penalty-free distributions can be taken for purposes other than retirement. When grandchildren need access to cash for higher education, to purchase a new home, or to make ends meet when unemployed, the inherited IRA is a ready source of needed cash.
Done right, IRA planning can stretch an IRA from a simple retirement account to a legacy perpetuating and wealth preserving estate planning device on par with the dynasty trusts and family banks of the ultra-wealthy. In contrast, without stretch planning, IRAs are more likely to dry up in the first beneficiary generation.
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