Imagine being able to provide your heirs, possibly for generations to come, with a really special gift – a tax break. Recent changes to the Individual Retirement Account distribution guidelines make such a benefit possible.
For years, the IRA has been a tool to save for retirement and defer tax payments until distribution. Once used solely as retirement vehicle, the IRA is increasingly being used in planning strategies for passing wealth to your heirs. In this use, an IRA is known as a “stretch” IRA. Establishing a “stretch” IRA allows the period of tax-deferred earnings to extend – “stretch” – beyond the life of the original owner.
“Stretch” IRAs are gaining in popularity for two reasons: First, it’s a relatively simple technique that can potentially save your heirs a great deal of money in taxes. Second, there are a growing number of affluent retirees who have enough income without completely depleting their IRA funds, thus leaving these funds available for inheritance.
Generally, here’s how a “stretch” IRA works:
In most cases, the money is left to a spouse. The spouse will roll the money into an IRA in his or her name and select a younger beneficiary (“X”), often a child. The spouse must take at least required minimum distributions (RMDs) beginning at age 70 ½. Once the spouse reached age 70 ½, ongoing RMDs must be taken annually based in part upon his/her life expectancy.
When the spouse dies, distributions go to X, who now “owns” the inherited IRA. The schedule of RMDs for X will be based on X’s life expectancy reduced by one for each year. X then names a new beneficiary of the IRA. When X dies, payments continue to the new beneficiary on the same schedule established by X.
Although each new inherited IRA owner can designate their own inherited IRA’s beneficiaries, the RMD payment schedule remains locked in. Assets in the “stretch” IRA continue to grow tax deferred and, if managed wisely, can increase well beyond their original value. Taxes only are paid on distributions, so additional savings are realized when the funds are paid out over time instead of in a lump sum which would be fully taxable.
“Stretch” IRAs aren’t right for everyone and you should be careful of claims by salespeople about how much of a return you can anticipate. Such predictions are often based on a few general assumptions that may or may not apply to your particular situation.
Before you decide to establish a “stretch” IRA, you should understand and consider these basic assumptions on which many “stretch” IRA models are built:
n You don’t need your IRA money for your retirement. This means you have adequate funds elsewhere and will have IRA funds remaining at your death to pass to your heirs.
* You take only the minimum distribution out of your IRA that’s required and start taking it at the latest possible time allowed without penalty – age 70 ½.
* Your beneficiaries die before all the IRA funds are distributed and there are remaining funds to pass on.
* Tax laws stay the same for the life of the IRA. We already know that the current estate tax exemption will be changing over the next few years and will return to prior law in 2011, unless Congress extends the exemption.
* There is no or little inflation. A high rate of inflation will impact the purchasing power of your “stretch” IRA dollars. A realistic example of your potential investment value should include adjustments for a reasonable rate of inflation.
* The rate of return on your IRA investment stays constant. For estimating purposes, “stretch” IRA models often use a constant rate of return projected over the long term. In the real world, returns are rarely constant and projecting them with precision over many years can be difficult.
Even taking into account these assumptions, “stretch” IRAs can be a solid estate planning strategy. To see if a “stretch” IRA is right for you, talk to your financial services provider.
Susan Davis is senior trust administrator for Wells Fargo Private Client Services in Colorado Springs.