Death & Taxes

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The New S-t-r-e-t-c-h IRA

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By Roy Lewis

There is a bunch of money kickin' around in traditional IRAs these days. It may have come from large corporate pension plan rollovers, or it may just be that traditional IRAs have increased in value through Foolish investments. Or both. Regardless, an increasing number of people are retiring with large traditional IRA balances.

But, what happens when an IRA owner dies? Typically the surviving spouse (let's use the wife for purposes of our discussion... sorry guys, but that's usually the way it works out) takes the inherited IRA into her own account and names a new beneficiary. And, typically, that beneficiary is one or more of the children. When this is done, minimum required distributions (distributions required when the IRA account owner turns age 70 1/2) are normally determined based on the joint life expectancy of the surviving spouse (wife) and the new beneficiary (child).

When the surviving spouse (wife) dies, the account can continue to be paid out over the life expectancy of the beneficiary (child). Certainly the beneficiary has other options for this IRA, but let's assume that the beneficiary doesn't need all of the funds immediately and wants to take the IRA payout over the longest period of time possible, hopefully reducing the tax burden.

So far, so good. But what happens if the beneficiary (child) dies before the end of his or her life expectancy?

Because many IRAs are owned by folks in their 70s and 80s, a lot of these IRAs will be inherited by children in their 40s and 50s. Based on IRS tables, the life expectancy of a 45-year-old is almost 38 years. For a 50-year-old, it's a little more than 33 years. Heck, even for a 55-year-old it's almost 29 years. And, while we are certainly living longer, it's a good bet that not all of these beneficiaries will live out their life expectancies. So, then what happens?

Well, according to the IRS rules, when a non-spousal beneficiary (such as a child) dies, the account can continue to be paid out over the life expectancy of that beneficiary as if that person had lived to the end of his or her full life expectancy. That's great, but if the original beneficiary has not named a secondary or contingent beneficiary (which is unfortunately fairly typical), there is nobody available to which these continued payments can be made. Therefore, the trustee of the IRA normally distributes the remaining balance of the IRA. And, if the IRA is large, the tax liability can also be large.

But, in a recent Private Letter Ruling (PLR 199936052), the IRS shed some light on this very issue. The taxpayer who requested the ruling (let's call him Jay) was named beneficiary of his mother's IRA (let's call her Jill). When Jill died, her IRA was left in her name but under Jay's Social Security number. Minimum distributions were to be made over Jay's life expectancy.

Jay asked the IRS to rule on a number of issues, but the critical one was whether, as permitted by the IRA custodian, he could name a contingent beneficiary for the IRA account to provide for the possibility that he might die before the IRA is exhausted. In other words, Jay wanted to know if an IRA beneficiary could name a back-up beneficiary in the event that the original IRA owner (in this case Jill) failed to do so.

And, lo and behold, the IRS had no problem with this. The IRS said that naming a contingent beneficiary wouldn't change the amount of the minimum distributions Jay must take from the IRA. But, in the event of Jay's premature death, it would allow the IRA to be paid out over Jay's remaining life expectancy (as though he hadn't died).

So, what does this all mean? It means that, with proper planning and with the agreement of the IRA custodian, an IRA payout can be stretched over a number of generations.

Example: Marilyn has a large IRA. She names her son Rick as the primary beneficiary. She also (with the agreement of her IRA custodian) names her grandson Tyler as the contingent beneficiary. When Marilyn dies, Rick elects to remove the IRA funds over his life expectancy. Since Rick is only 45 years old, the payout will be made over about a 38-year period.

But, if Rick dies prematurely (let's say at age 50), Marilyn's grandson Tyler will still be able to elect to have the IRA paid out over the remaining 33 years of Rick's life expectancy... as if Rick never died at all. If Tyler is age 20 when Rick dies, Tyler will receive the benefit of the IRA payout for the next 33 years... or until he's almost 53 years old.

What happens if Tyler dies prematurely? Well, Marilyn might want to consider naming another contingent beneficiary to take Tyler's place and keep the payout going to another beneficiary (perhaps another grandchild) for the remainder of Rick's life expectancy.

Think how long Marilyn could have kept her IRA going if she would have bypassed her son and named her grandson as the original beneficiary, with another grandchild as the contingent beneficiary! It's possible that Marilyn's IRA payout could have been stretched over a 50-year (or longer) span of time after her death. Wow!

Is this something you should do independent of your overall estate planning? Nope. But, it's certainly something you might want to consider integrating into your estate plan. It's obviously a method by which any subsequent IRA distributions can be minimized over a number of years.

Is it difficult to accomplish? Not really. Most IRA custodians are now "up to speed" regarding the naming of a contingent IRA beneficiary, and they already have the paperwork available to allow you to name a contingent (and even a successor-contingent) beneficiary.

So, you'll want to check with your IRA custodian for the exact forms and wording required to accomplish your "stretch" IRA. Many accountants and/or financial planners are already knowledgeable on how a "stretch" IRA can benefit both you and your beneficiaries, so don't be afraid to ask them.

Finally, while an IRS PLR (Private Letter Ruling) technically doesn't set legal precedent, it does provide some insight into the thinking of the IRS for those who find themselves in similar circumstances. That is why many IRA custodians are jumpin' on the s-t-r-e-t-c-h IRA bandwagon. You might want to consider jumpin' on the bandwagon yourself.

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