Article by: Ladidas Lumpkins and Roman Katz
Ben Franklin once said that nothing is certain except death and taxes. The traditional Individual Retirement Account, also known as the IRA, was invented in 1974 and brings to bear both of those certainties.
With pre-tax dollars earning compound interest, your IRA over time can increase in value exponentially. At your death, you can pass your IRA to your beneficiaries. The question for them is, what are their options on how to draw down the money coming out of your hard-earned retirement savings? To answer that question, let’s begin at the beginning with what exactly IRAs are.
For starters, IRAs hold investments funded with pre-tax dollars. Those investments grow tax-free until retirement. Tax-deferred growth may allow your retirement savings to grow much faster than if they were held in a taxable savings account. Consider an investor who puts away $5,000 a year into an IRA for 10 years between the ages of 25 and 35. After her 70th birthday, she could have a retirement account worth half a million dollars!
At age 70 ½, IRA account holders must start taking minimum distributions. Whether owned or inherited, failure to take a required minimum distribution can lead to onerous tax results. The IRS can take half of what you should have withdrawn that year—yes, half of the distribution amount—as a penalty for failure to withdraw the minimum amount timely.
As to the certainty of taxes, when you do start taking mandatory distributions, you will be taxed on the amounts withdrawn. However, you are taxed based on your income at age 70 ½, which for many people will land them in a lower tax bracket.
Given that the current life expectancy for Americans is between 79 and 81, you will most likely get to enjoy the fruits of your investment for a while. Eventually, that other certainty comes around and now your IRA account will be inherited by your beneficiaries. So, how does that work?
One bit of good news is that with an IRA, after an account holder’s death, you have choices. The investment vehicle continues to benefit from compounding growth and can make distributions to beneficiaries right away or over time with “stretching”. Stretching is a wealth transfer tool that allows the benefits of tax-deferred growth to extend over future generations. Depending on intricate IRS rules governing categories of owners and inheritors, “stretching” an IRA can mean:
- Distributing the IRA within 5 years of the owner’s death;
- Distributing based on what would have been the owner’s life expectancy,
- Or, distributing based on the life expectancy of the beneficiary.
All of this is subject to Treasury Regulations so consult with your tax advisor to find out how to get the most out of your planning.
Any plans to stretch an inherited IRA center around beneficiaries and time. So, who are the beneficiaries of an inherited IRA?
Beneficiaries are individuals or entities named as a beneficiary of the IRA account as of the date of the owner’s death. “Designated” beneficiaries are statutorily defined. It includes those individuals or eligible entities that have not cashed out or disclaimed their interest as of September 30th of the year after the year of the owner’s death, a key date in post-mortem IRA planning.
Spouses, Non-Spouse Individuals, Estates and Charities all have the option to distribute the entire balance of an IRA in a single tax year. This is a Lump-Sum Distribution.
A spouse, unlike any other beneficiary, can transfer the assets from the IRA into her own IRA as if the IRA had been hers originally.
The remaining options depend on the age at which the original owner passes away.
If an owner dies before the age of 70 ½ :
- Spouses, Non-Spouse, Individuals, Estates and Charities may all distribute the entire IRA balance prior to the end of the fifth year following the owner’s death. This is often referred to as the “Five-Year Rule”. The Five Year-Rule also applies when the account holder fails to name a beneficiary. Additionally,
- Spouse and Non-Spouse Individuals may take distributions for a longer period based on their life expectancy.
If the owner dies after the age of 70 ½:
- Spouses, Non-Spouse Individuals, Estates and Charities may be able to distribute based on what would have been the owner’s life expectancy (Ghost Life Expectancy Rule). Or,
- Spouse and Non-Spouse Individuals may be able to take distributions for a period based on their life expectancy.
As might be expected, trusts as IRA beneficiaries are more complicated. Whether a trust qualifies as a designated beneficiary depends on whether or not it meets the IRS requirements for a “See-Through” trust, also called “Look-Through” trust.
See-Through requirements include:
- The trust is valid under state law;
- It is irrevocable or becomes irrevocable at the death of the account holder;
- The beneficiaries are identifiable from a reading of the trust instrument, and
- Appropriate documentation is provided to the IRA custodian by October 31 of the year following the IRA owner’s death.
A trust that meets the requirements for a See-Through trust can stretch IRA distributions to the beneficiaries over the lifetime of the oldest beneficiary. This could provide a powerful savings opportunity, particularly if the oldest beneficiary is much younger than the original account holder, such as a grandchild or great grandchild. If a trust fails to qualify as a See-Through trust, it is treated under IRS rules in the same way as an Estate or Charity beneficiary. When creating a See-Through trust, make sure an attorney reviews the language in the trust to make sure it will let you stretch those IRA assets the way you want.
An IRA inheritance with Multiple Beneficiaries can also complicate matters. The following is a brief list of some of the issues to watch for with Multiple Beneficiaries:
- The beneficiary’s age used to stretch the IRA must be the oldest beneficiary
- A single IRA can be split into separate accounts for each beneficiary if you do this by the end of the year following the year of the IRA owner’s death
- If there are individuals and entities receiving funds from an IRA, the beneficiary group will use the most constrictive option available. So, if you have a trust that does not qualify as a See-Through trust, an Estate or a Charity, you may be stuck with only stretching over five years.
- To eliminate a beneficiary, which you may want to do in favor of a beneficiary that provides for greater accumulation and transfer of wealth, prior to September 30th of the year after the owner’s death, the beneficiary must either disclaim their interest in accordance with applicable federal and state law or receive a lump sum distribution in full satisfaction of their interest.
One can wonder if even a person as brilliant as Ben Franklin could have foreseen any savings vehicle as nuanced as the IRA, or the many issues that the inheritors of an IRA must confront. But we should not forget that it was also Franklin who said: “A penny saved, is a penny earned.”