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Teach your IRA beneficiaries to stretch

Published: Wednesday, Feb. 27, 2013 5:30 a.m. CST • Updated: Friday, March 1, 2013 11:26 a.m. CST

Americans saving for retirement are well aware of the tax benefits that individual retirement accounts confer on account holders. Fewer are familiar with the rules that offer tax savings to IRA heirs. These special “stretch” distribution rules can help you transfer wealth across one or perhaps two generations.

Most people understand how money ends up in IRA plans, but they may not understand how it comes out later and what happens after they pass on. They may be missing out on a powerful estate planning tool that’s also easy to use. Here’s how it works and how it might make a difference to your estate planning.

• Defining the stretch. Rather than a product – such as a particular type of IRA – stretching is a distribution strategy that can be applied to any type of IRA. Under the strategy, beneficiaries can make withdrawals from the inherited account over years or decades.

Under the stretch strategy, required minimum distributions are calculated based on the beneficiary’s life expectancy.

For example, say a 60-year-old man inherits an IRA from his father. He can schedule distributions over his 25-year life expectancy, as determined by the IRS single life expectancy table. The first year after inheriting the IRA, this beneficiary would be required to withdraw only 1/25th of the account’s value. The next year, he would withdraw 1/24th of the account’s value, and so on.

The appeal of the stretch provision is that the longer the beneficiary’s life expectancy, the smaller the amount he or she must withdraw each year – allowing the bulk of the funds in that IRA to continue to grow tax-deferred.

It’s a powerful way to preserve the family’s wealth. IRAs are part of your taxable estate, but they can continue to grow on a tax-advantaged basis long after the IRA owner is gone.

• Setting up a stretch strategy. The stretch strategy won’t have any implications for your IRA during your lifetime: Stretching can be used only by the beneficiaries of an inherited account, although you can enhance the amount to be left behind by taking no more than your annual required minimum amount once you reach age 70½. But if you expect to include an IRA in your estate, you can take a few important steps to prepare your account for potential stretching:

1. Check the details of your IRA custodial agreement. Most IRA custodians will allow beneficiaries to use the stretch provision, but some may require faster payouts.

2. Choose beneficiaries carefully and indicate them on your IRA beneficiary form. This may be the most important step in the stretch process. It is important to understand that if you name your estate as an IRA beneficiary, your estate has no life expectancy, and therefore can’t use the stretch provision. Instead, your heirs might have to withdraw all the money from that account within five years, per IRS rules. Likewise, spouses typically don’t need to use a stretch strategy because IRS rules allow spouses to roll inherited accounts into their own IRAs.

Children or grandchildren are ideal beneficiaries for potential stretching. Because they tend to have longer life expectancies upon inheritance of an IRA, they are more likely to reap the most benefits of tax-advantaged growth.

Make sure to update your beneficiary forms after important life changes, such as births, deaths, marriage or divorce. IRA beneficiary forms supersede anything written in your will!

3. Educate your heirs. Make sure they understand how to enact a stretch strategy. Most important, they should appreciate the intent of the gift and grasp the benefits of not simply cashing out the account. Second, they need to sidestep pitfalls. For example, non-spousal beneficiaries who want to move the account from one IRA custodian to another must use what’s called a “trustee-to-trustee” transfer in order to avoid triggering immediate taxes on those funds.

I can help you and your family understand inherited IRA rules. Once your heirs see the benefits of the stretch provision, they’re likely to recognize what a significant gift you plan to leave them.

• Timothy J. O’Connor is first vice president, investment officer and certified financial planner with Wells Fargo Advisors, 2424 Lake Shore Drive, Woodstock. Email timothy.oconnor@wellsfargoadvisors.com, or visit http://home.wellsfargoadvisors.com/timothy.oconnor.

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