Inherited IRAs: Understanding the Options Can Make a World of Difference

Your Beneficiaries Can Stretch Your IRA Assets Over Their Life Expectancies

Chances are you have an IRA. And while it’s not the most pleasant subject, it's important to understand the options available in passing your assets on to your beneficiaries.

Today IRAs hold over $4 trillion of assets, more than any other type of retirement plan.

And while an IRA can be an important vehicle for funding your retirement years, it can also be an important part of the legacy you leave to your loved ones. And if you and your beneficiaries know the available options, you can stretch out the tax benefits for years.

The law provides IRA beneficiaries some flexibility. There are different options for spouse and non-spouse beneficiaries that avoid the immediate taxation of a potentially significant sum of money. A spouse may be able to defer taxation to a later date by transferring the IRA into his or her own name. Non-spouse beneficiaries do not have this option. They can, however, choose to receive the money in the IRA slowly, via distributions over their own life expectancies, thereby spreading out the tax burden over a longer period of time. Tax laws surrounding inherited IRAs are quite complicated. You should seek the advice of a tax professional if you own or have inherited an IRA.

Stretch IRA Rules Provide Flexibility
If you have the flexibility and it aligns with your legacy goals, you may want to consider the stretch IRA rules. These rules can help your IRA assets provide a substantial benefit to your beneficiaries. For example, leaving your IRA assets to a beneficiary with a longer life expectancy may allow more of your IRA assets to remain in the account with the potential to grow tax-deferred for a longer period of time.

If Your Beneficiary is Your Spouse
A spousal beneficiary has the most options, since a spouse can roll your IRA over to a new or existing IRA in his or her own name and designate new beneficiaries. If your spouse has not yet reached the date by which he or she is required to take distributions from the IRA account (age 70½), the assets can remain in the account with the potential to grow tax-deferred until he or she reaches 70½. If your spouse is several years away from age 70½, naming your spouse as beneficiary may be the best strategy to take advantage of the stretch option.

Options for Other Beneficiaries
Although persons other than your spouse have more limited distribution choices, they can still extend the life of your IRA. These beneficiaries may be able to take distributions based on their own life expectancies—stretching out distributions for over 30 or 40 years in some cases.

Here's an example that shows the effect of stretching out the distributions using an inherited IRA. Say a 36 year-old inherits an IRA worth $500,000 when his father dies, and let's assume that he chooses to stretch his receipt of the money over his lifetime by taking only the required minimum distribution each year (based on his life expectancy).

The first graph shows the year-by-year Required Minimum Distributions (RMDs). These distributions increase each year as the individual gets older. The second graph indicates the value of the IRA over time. Notice that in the early years, the account grows at a faster rate than the person's annual withdrawals. However, the required withdrawals increase each year, and by age 65, they exceed the growth of the IRA. At that point, the balance in the IRA begins to decline from the RMDs that are taken.

Nevertheless, by age 75, the individual in this example has withdrawn $1,720,512 from the inherited IRA, and he still has over $900,000 left in the IRA account!

This is just one example of the legacy you can create for your IRA beneficiaries. Of course, the younger the beneficiary, the more time one has to stretch out distributions and the greater the potential legacy.

Leaving a Legacy Things to Consider When Choosing Beneficiaries
Naming beneficiaries for your retirement accounts may seem like an easy task. Remember, though, it is also one of the most important decisions you will make. The beneficiary form on file with the custodian of your IRA controls both who inherits it and its ability to be stretched out. Therefore, you should give it the time and attention it deserves. By working with your insurance professional, you can help ensure not only that your assets go to the beneficiaries you want, but also that the assets may have the potential to grow tax-deferred for years to come.

No matter whom you choose, though, it's important that you make that choice and complete the appropriate documentation. If you don't, the tax consequences for your beneficiaries could be devastating.