Stetch Your Retirement Savings

With the significant run-up in the stock market over the past decade, and with the increased popularity of 401k plans and other retirement accounts, many people have a surprisingly large portion of their estate in some kind of Qualified Retirement Account such as IRAs, SEP-IRAs, and 401K Plans. For this discussion we will simply refer to IRAs, although most of the rules will apply to other qualified retirement accounts, too.

The question inevitably comes up in the context of estate planning: "Who should be the beneficiary of my IRA?" The answer may be quite simple, but usually it's not! Fortunately, as a result of sweeping new regulations issued by the IRS in January of 2001 and revised again in April, 2002, the possibilities are not quite as thorny as they used to be. Let's look at some of the issues that must still be considered.

DECISIONS, DECISIONS!

First you have to decide who you want to actually receive the money. (Obviously!)

Does your spouse need the money to live on if he or she survives you?
If you leave the IRA to children or grandchildren, what will happen to the money - or more importantly, what will the money do to them?
Will "equal" shares for your children be "fair" in light of their respective needs, and considering what other assets your children may be receiving?
Might this be a good asset to leave to your church or favorite charity?
The "general rule" is that I can't leave my IRA to a trust; what exceptions are there to the general rule, and might I be able to get multiple benefits by leaving the IRA in trust rather than outright to any particular person?

Then you should consider the estate tax implications:

If I leave the IRA to my spouse, it will be included in his or her taxable estate and create a greater estate tax liability at their death. Could that be avoided?
If I leave it to my children instead of my spouse, will that trigger estate taxes at MY death, which could be avoided by leaving it to my spouse?
If I leave the IRA to my grandchildren, what about the Generation-Skipping Transfer Tax? At 55%, that might be a disastrous result!

Finally, you must consider the income tax issues:

How can I stretch the income tax deferral for as long as possible?
What about a "spousal rollover" and how does that improve the income tax deferral?
Can't my children take withdrawals over a long period of time, and defer income taxation until they get those withdrawals?
If I leave it to someone who is too young to have good judgment, even the best income tax deferral opportunities will be lost if they "cash in" the IRA right away (to buy a new car or something like that).

With all of these questions to sort through, selecting the right beneficiary to name on your IRA account is a minefield! Don't get an arm or leg (or a large chunk of your IRA) blown off by a tax "mine" or other predator! Often we have clients come in who have heard about a single concept - the Stretch IRA - and their financial advisor has advised them of only one thing: income tax deferral. In the Pyramid of estate planning issues, tax planning should be the last thing that drives your decisions, not the first. Once the other issues (like who do you want to receive the money and what might it do to or for them) are addressed, then usually there are still plenty of income tax deferral opportunities to be had - and we can help you find them.

TIPS: AVOID THE MAJOR PITFALLS

Here are some basic guidelines to keep in mind. These are only the tip of the iceberg, so take these ideas to a knowledgeable professional and figure out the right answer with their help.

TIP 1: Whatever you leave to your spouse will be included in their taxable estate when they die, unless they have spent it all and have nothing to show for their spending! The easiest way to avoid estate taxes at the first death (for a married couple) is to leave everything to the surviving spouse. But this is also the best way to pay unnecessary estate taxes at a later time. Don't be lured into that trap - it's an IRS favorite!

TIP 2: You can leave the IRA in a trust that will be used to take care of your spouse, but which will not be included in your spouse's estate when he or she dies later. For example, the trust could provide that your spouse can take income, and principal if needed, from the IRA, and use those funds to maintain their standard of living. The trust must meet specific qualifications, or else income tax deferral and estate tax avoidance will be missed.

TIP 3: If you leave your IRA to grandchildren, it may offer a terrific income tax deferral opportunity. But if you do, remember that you named a young person who may lack appreciation of the value of money and savings, but may have a great appreciation for fast, red cars! By naming them as beneficiary, you also give them the ability to draw all of the money out as soon as you die or they are of age. While they have a tax deferral opportunity, they may prefer to pay their taxes NOW and have the net proceeds NOW. Instead, you can obtain the same tax-deferred "stretch-out" treatment by naming a trust FOR the grandchild as beneficiary, and appointing a more mature adult (perhaps the parent of the grandchild) as Trustee for the grandchild. Then the money will only be taken, and taxes paid, as fast as the law requires - giving them the long tax deferral - or as fast as the older Trustee thinks the grandchild needs the money. This helps assure the stretch-out treatment will WORK the way you intend!

TIP 4: Naming a child as beneficiary generally offers better income tax deferral than leaving it to your spouse. But your spouse doesn't get the money! Alternatively, if you name your spouse as the primary beneficiary and you are satisfied that your spouse will name the children as beneficiaries to receive it at your spouse's death, that might offer an even longer tax deferral - but you have no way of controlling that once it goes to your spouse. If they remarry, they might decide to leave it to their NEW spouse. Also, in some states, that new spouse will have a legal right to take part of the IRA at your spouse's death, even if your spouse named your children as beneficiaries. Ouch!

TIP 5: If you name your children as direct beneficiaries, when they receive the IRA at your death the IRA is immediately exposed to "predators" in their life. To varying degrees, the IRA proceeds could be seized by an unwanted creditor (such as from a lawsuit brought against your child), by long term care costs (ie. your child's health fails and they are hospitalized or placed in a nursing home) or a divorce. Leaving the IRA to a trust FOR your children can prevent these kinds of predators, yet still give your children the access you want them to have.

TIP 6: If you name your grandchild or a trust for a grandchild as beneficiary, the IRA will be subject to the Generation-Skipping Transfer Tax? At 55%, this can consume over half of the account! And where does the family get the money to pay that tax (or any other estate tax)? Draw it out of the IRA, you say? If they do, then they incur income tax on every dollar withdrawn and lose tax deferral that the "stretch-out" opportunities offered.

TIP 7: Your IRA should be thought of as "illiquid." If your IRA is significant in size you should obtain life insurance, properly owned in a special kind of trust to keep it from being taxed, to make the funds available to your heirs to pay the estate taxes on the IRA. If you want the family to maximize their tax deferral, you have to think of the IRA as not available in a lump sum to satisfy an estate tax bill. Remember that life insurance owned by you or your spouse IS subject to estate tax. Contrary to popular belief, life insurance IS TAXABLE as part of your estate or your spouse's estate if either of you own it. And if your children own it, then it is subject to claims of their creditors, divorces, etc. A life insurance trust, properly structured to match the distribution provisions of the rest of your estate, is clearly the best way to own life insurance.

CONCLUSION

Deciding who to name as beneficiary of your IRA is a major estate planning decision. Usually people make that decision with only a tiny fraction of the information they really need. Fortunately, under the "final regulations" (yeah, right, what is ever "final" with the IRS?) issued April 2002, we can change beneficiaries without incurring any penalty or loss of tax deferral. No matter who you named or what mistakes you might have made, chances are very good that you can correct those mistakes now.

You should get with a knowledgeable professional to discuss the implications of who you name as the designated beneficiary. A financial advisor should have some of the answers; a legal counselor will help fill in the missing links.