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The KRASA LAW, Inc. Estate Planning Blog

Monday, October 21, 2013

Will You Get a Second Stretch?

Defined contribution retirement plans such as IRA’s and 401(k) plans are governed under special, and sometimes complicated, tax rules.  Not being aware of these special rules can force you or your beneficiaries to pay taxes at an accelerated rate and miss out on the special investment opportunities that are the key features to these kinds of plans.  Conversely, understanding these unique rules can allow you or your loved ones to make smarter tax and investment decisions.

The general rule with regard to these kinds of plans is that you receive a tax deduction for the amount of money you put into the plan, the asset grows inside the plan in a tax-deferred manner allowing compound interest, and you only pay tax when you take a distribution from the plan. 

As my tax law professor taught me, the basic concept behind the rules governing IRA’s and 401(k) plans is the “Goldilocks Rule”: “not too soon; not too late; but just right.” 

If you take a distribution from your own plan too early (before the year after you reach age 59.5), with a few exceptions, you will be charged at 10% penalty as the purpose of the plan is to provide for retirement and taking an early distribution frustrates that intent. 

At the same time, the rules require that you take an annual minimum distribution from the plan after you reach age 70.5 because again the purpose of the plan is to use the assets for retirement.  These annual Required Minimum Distributions (“RMD’s”) are based upon your life expectancy as determined by IRS tables.

Keeping as much of the assets in the plan as possible and limiting distributions to the RMD’s to take advantage of the tax deferred compound interest the plan provides is known as “stretching the plan.”  Sometimes this is referred to as a “stretch IRA,” but the concept can often work for 401(k)’s and other similar plans as well.       

For a non-spouse beneficiary of a plan, provided that the beneficiary was properly designated within the IRS rules, the beneficiary will be able to delay full distribution of the plan and base RMD’s on his/her own life expectancy.  The younger the beneficiary is, the lower the RMD’s will be, the longer he/she will be able to keep the plan, delay unnecessary income taxes, and keep as much in the plan as possible to enjoy the tax-deferred compound interest.  This is a significant benefit. 

The beneficiary will also be able to name his/her own successor beneficiary.  The successor beneficiary will be able to stretch the distributions from the plan based upon the first beneficiary’s life expectancy, but will not be able to base RMD’s on his/her own life expectancy. 

A spouse beneficiary can elect to be treated as a non-spouse beneficiary and follow the exact same rules as above, which means that the spouse’s successor beneficiaries (in many cases the children) will not be able to base their RMD’s on their own life expectancies after they inherit from the surviving spouse.  Instead, the children would have to base RMD’s on the parent’s life expectancy, which would be much shorter than the children’s life expectancy and would require distributions from the plan to occur at a much more rapid rate.   

However, the surviving spouse has a special option that is not available to any other beneficiary: the surviving spouse can elect a “spousal rollover” which means that the surviving spouse will be treated as if he/she owned the plan from the very beginning.  In this scenario, when the surviving spouse designates his/her own successor beneficiaries, those beneficiaries will be able to stretch distributions from the plan based upon their own life expectancies.  This gives a “second stretch” to the plan: the first stretch for the surviving spouse and the second stretch for the children. 

This difference of whether the children are permitted to base RMD’s from the plan on their own life expectancies or are forced to base RMD’s on their parent’s life expectancy can sometimes be a very stark contrast with significant financial impact. 

Most retirement plan custodians automatically treat a spouse as any other beneficiary and do not alert the surviving spouse to the possibility of the spousal rollover.  While there might be some unique circumstances that do not make the spousal rollover the optimum choice for everyone, it is always worth considering whether electing to take a spousal rollover would be appropriate. 

A qualified attorney can help you decide whether the spousal rollover option is the right course of action given the situation.

This article is for general information only.  Reading this article does not create an attorney/client relationship.  You should consult a qualified attorney licensed to practice law in your community before acting on any of the information presented in this article. 

Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, any tax advice contained in this communication, including attachments thereto, was not written to be used and cannot be used for the purpose of (a) avoiding tax-related penalties under the Internal Revenue Code or (b) promoting, marketing or recommending to another party any tax-related matters addressed herein.


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