A significant degree of wealth is currently held in Individual Retirement Arrangements (“IRA’s”). Most people focus on accumulating wealth in IRA’s – saving, contributing, and investing. However, very few people contemplate the best methods for transferring IRA’s to the next generation. The tax rules regarding IRA’s are unique and complex. Failure to properly address IRA’s in your estate planning often causes unnecessary tax and loss of opportunities for your beneficiaries. Conversely, understanding how to properly navigate the unique IRA taxation rules increases their value for your loved ones.
IRA’s are savings / investment vehicles that have special tax treatment which allows the assets to grow in a tax-free or tax-deferred manner. A Traditional IRA offers a tax deduction for contributions made but requires income tax to be paid on every dollar withdrawn from the plan. Roth IRA’s offer the reverse approach: no tax deduction for contributions made but no tax on amounts withdrawn from the plan. Both types of IRA’s provide compound interest which allows the investments to grow at a rapid rate.
The purpose of these special tax rules with regard to IRA’s is to encourage retirement savings. Both Traditional IRA’s and Roth IRA’s prevent you from withdrawing funds without penalty before attaining age 59.5 except under certain specified conditions. The idea behind this rule is to ensure that, in general, the IRA funds are being used for retirement and not for vacations, boats, cars, etc. With regard to Traditional IRA’s, the rules require the IRA owner to begin making Required Minimum Distributions (“RMD’s”) by the year after the year in which the IRA owner attains age 70.5. The RMD’s are based upon the IRA owner’s life expectancy according to tables published by the IRS. The idea behind this rule is to once again ensure that the IRA funds are being used for retirement and not to create a legacy for the next generation. With regard to Roth IRA’s, the IRA owner does not have to begin taking RMD’s, but the beneficiaries of a Roth IRA will have to take RMD’s.
When it comes to inheriting IRA’s, it is advantageous for your beneficiaries to leave as much of the assets in the IRA’s as possible in order to take advantage of the compound interest. If your beneficiaries simply cashed out their inherited IRA’s, they would pay significant income tax immediately on Traditional IRA’s and with regard to both Traditional IRA’s and Roth IRA’s, would sacrifice the opportunity for compound interest years into the future. Under certain circumstances and with careful planning, beneficiaries of IRA’s may “stretch out” IRA distributions over their lifetimes.
The key is to make sure that you have a “designated beneficiary” of your IRA’s. First, failure to name any beneficiary at all will force your beneficiaries to liquidate the IRA’s at a very rapid rate, realizing immediate taxation and foregoing years of compound interest. Secondly, failure to name the “correct” beneficiary might produce the same result. A “designated beneficiary” is a defined term that generally means a living individual (as opposed to an estate) or a trust under certain specified conditions.
Even if you set up the beneficiary designations correctly to allow your beneficiaries to stretch out their inherited IRA’s, your beneficiaries must be educated on the benefits of keeping as much of the assets within the IRA vehicle as possible, otherwise they might liquidate the IRA’s immediately or more rapidly than necessary without realizing what they are sacrificing.
Furthermore, if you have concerns that your beneficiaries might not have the financial discipline or wisdom to limit distributions from their inherited IRA’s, you might want to consider establishing an estate plan that encourages or even forces your beneficiaries to limit withdrawals from inherited IRA’s to allow the compound interest to continue.
Focusing on accumulating wealth in IRA’s is only half the battle. The other half is to focus on how you can transfer your IRA’s to the next generation in the most advantageous manner. If you have a significant amount of wealth in IRA’s, it would be prudent to work with a qualified attorney to ensure that this important part of your IRA planning is addressed properly.