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Transferring Wealth With Multigenerational IRAs

Key Points



Whether you've amassed assets in an individual retirement account (IRA) by making regular contributions through the years or by "rolling over" a lump-sum distribution from a workplace retirement plan, you may want to consider whether it will be necessary to use all of that money to support yourself during retirement.

If the answer is "no" (or even "maybe not") then you'll need to determine the most efficient way of leaving the account balance to your heirs while simultaneously safeguarding your accumulated wealth for as long as possible.

 

Stretch Strategy

For many Americans, transferring wealth with a multigenerational "stretch" IRA is an ideal solution.

A stretch IRA is a traditional IRA that passes from the account owner to a younger beneficiary at the time of the account owner's death. Since the younger beneficiary has a longer life expectancy than the original IRA owner, he or she will be able to "stretch" the life of the IRA by receiving smaller required minimum distributions (RMDs) each year over his or her life span. More money can then remain in the IRA with the potential for continued tax-deferred growth.



Creating a stretch IRA has no effect on the account owner's minimum distribution requirements, which continue to be based on his or her life expectancy. Once the account owner dies, however, beneficiaries begin taking RMDs based on their own life expectancies. Whereas the owner of a stretch IRA must begin receiving RMDs after reaching age 70½, beneficiaries of a stretch IRA begin receiving RMDs after the account owner's death. In either scenario, distributions are taxable to the payee at then-current income tax rates.

It's worth noting that beneficiaries also have the right to receive the full value of their inherited IRA assets by the end of the fifth year following the year of the account owner's death. However, by opting to take only the required minimum amount instead, a beneficiary can theoretically stretch the IRA - and tax-deferred growth - throughout his or her lifetime.

If you do not currently have any IRA beneficiaries, employing the stretch technique by naming a beneficiary could provide significantly more long-term benefits than simply allowing the account balance to be paid out to your estate as a taxable lump-sum distribution - particularly if the value of the IRA causes the overall value of your estate to exceed the lifetime estate tax exclusion, currently $5 million. Note that this exclusion is currently scheduled to be reduced to $1 million in 2013 unless extended by Congress. Any amount in excess of the exclusion would be taxable at estate tax rates, which top out at 35% in 2011 and 2012.

So if you're unlikely to deplete your IRA assets during retirement, consider creating a multigenerational stretch IRA. By doing so, you could minimize your own estate's tax burden while also helping to build long-term financial security for a loved one.

Added Perspectives

Your enhanced ability to stretch IRA assets is a direct result of an IRS decision to simplify the rules regarding RMDs from IRAs. The new rules allow beneficiaries to be named after the account owner's RMDs have begun, and beneficiary designations can be changed after the account owner's death (although no new beneficiaries may be named at that point.) Also, the amount of a beneficiary's RMD is based on his or her own life expectancy, even if the original account owner's RMDs had already begun.

Consider the Implications

  • The ability to name new beneficiaries after RMDs have begun means that you can include a child in your stretch IRA strategy regardless of when the child was born.
  • The ability to change beneficiary designations after the account owner's death means that one beneficiary may choose to disclaim his or her own beneficiary status so that more assets pass to another beneficiary. For example, if an account owner names his son as the primary beneficiary and his grandson as the secondary beneficiary, the son could remove himself as a beneficiary and allow the entire IRA to pass to the grandson. RMDs would then be based on the grandson's life expectancy, not on the son's life expectancy, as would have been the case if the son remained a beneficiary. (When there is more than one beneficiary, RMDs are calculated using the life expectancy of the oldest beneficiary.)
  • The ability of beneficiaries to base RMDs on their own life expectancy means that the money you accumulate in your IRA and leave to heirs has the potential to last longer and produce more wealth for younger generations. (See example.)



Keep in mind that this information is presented for educational purposes only and does not represent tax or financial advice. While it's true that recent regulatory changes have indeed made it much easier to incorporate a stretch IRA into your multigenerational financial planning initiatives, it's always a good idea to speak with a tax professional before implementing any new tax strategy.

Case in Point: A Stretch IRA in Action
Assume that you leave a $100,000 IRA to a five-year-old beneficiary who has an estimated life expectancy of 77.7 years, according to current IRS life expectancy tables. If the account earned an 8% average annual rate of return, its value could grow to $1.67 million by his or her 55th birthday. And that amount is on top of the nearly $790,000 in taxable RMDs that would have been withdrawn from the account during the 50-year time period.*
*For illustrative purposes only. Not indicative of any particular investment.

 

Points to Remember

  1. A multigenerational "stretch" IRA makes it possible for individuals who do not expect to deplete IRA assets during retirement to maintain the account's tax-deferred status and reduce the amount of required minimum distributions (RMDs).
  2. This is accomplished by naming a younger individual as the primary beneficiary. Because that individual has a longer life expectancy, RMDs will be smaller and more money can remain in the account with the potential to earn additional tax-deferred investment returns for younger loved ones.
  3. Current IRS rules allow increased flexibility regarding the timing of and changes to beneficiary designations.
  4. A primary beneficiary can extend the life of a stretch IRA even longer, by disclaiming his or her beneficiary status and allowing the entire account balance to pass along to an even younger secondary beneficiary.
  5. Consult a tax professional before implementing your stretch IRA strategy.

© 2011 McGraw-Hill Financial Communications. All rights reserved.