The "stretch" provision is one you might be interested in if you are using your IRA primarily to provide for your beneficiaries. That is, if your retirement needs will be funded by other assets (lucky you!. Then, you may want to take advantage of this provision in order to structure flows to persons other than yourself.
Identifying the Concept
Does your IRA allows the beneficiary to distribute the assets over a life-expectancy period and also allow him or her to designate a second-generation beneficiary of the inherited IRA? If so, it is this provision that allows a beneficiary to designate a second-generation beneficiary (and even a third, fourth and so on)that determines whether the IRA has the "stretch" provision. It allows the IRA to be passed on from generation to generation, thereby stretching the life of the vehicle.
How It Works
The beneficiary must follow certain rules to ensure he or she doesn't owe the IRS excess-accumulation penalties, which are caused by failing to withdraw the minimum amount each year. How so?
Let's use an example:
Huey's designated beneficiary is his son Dewey. Huey dies in 2008, when he is age 70 and Dewey is age 40. Dewey's life expectancy is 42.7 (determined in the year following the year Huey died, when DDewey is age 41). This means that Dewey is able to stretch distributions over a period of 42.7 years. Dewey elects to stretch distributions over his life expectancy, and he must take his first distribution by Dec 31, 2009, the year-end following the year Tom died.
To determine the minimum amount that must be distributed, Dewey must divide the balance on Dec 31, 2008, by 42.7. If Dewey withdraws less than the minimum amount, the shortfall will be subject to the excess-accumulation penalty. To determine the minimum amount he must distribute for each subsequent year, Dewey must subtract 1 from his life expectancy of the previous year. He must then use that new life-expectancy factor as a divisor of the previous year-end balance.
Now, remember our assumptions. The IRA plan document allowed Dewey to designate a second-generation beneficiary, and he designated his son Louie. If Dewey were to die in 2013, when his remaining life expectancy is 38.7 (42.7 - 4), Louie could continue distributions for Dewey's remaining life expectancy. It is important to note that only the first-generation beneficiary's life expectancy is factored into the distribution equation; therefore, Louie's age is not relevant.
In this example, Huey could have chosen to designate Louie as his own beneficiary, resulting in a longer stretch period. In such a case, Louie would be the first-generation beneficiary, and his life expectancy instead of Dewey's would be factored into the equation.
Primary Benefits of the Stretch Concept
Tax Deferral
The primary benefit of the stretch provision is that it allows the beneficiaries to defer paying taxes on the account balance and to continue enjoying tax-deferred and/or tax-free growth as long as possible. Without the stretch provision, beneficiaries may be required to distribute the full account balance in a period much shorter than the beneficiary's life expectancy, possibly causing them to be in a higher tax bracket and/or resulting in significant taxes on the withdrawn amount.
Flexibility
Usually, the stretch option is not a binding provision, which means the beneficiary may choose to discontinue it at anytime by distributing the entire balance of the inherited IRA. This allows the beneficiary some flexibility should he or she need to distribute more than the minimum required amount, say in the case of a financial emergency.
Benefits for Spouses
Remember, a spouse beneficiary is allowed to treat an inherited IRA as his or her own. When the spouse elects to do this, the spouse beneficiary is given the same status and options as the original IRA owner and the stretch concept is not even in play. However, should the spouse choose to treat the IRA as an inherited IRA, then the stretch rule may apply.
Conclusion
Consult your current IRA provider or financial institution if this concept is of interest to you. IRAs can be transferred if this provision is not present in your provider's IRA plan documents. Finally, be sure to consult with your tax and financial professional for assistance. This concept must mesh with your financial profile and your wealth-management goals.
For the IRA scenario Mark articulates here, it is critically important to estimate the real-life, situation-specific scenarios because every case is so different. Some considerations:
ReplyDeleteThe inherited IRA that EACH non-spouse beneficiary has to set up as the result of inheriting IRA monies is then required to be distributed over a life-expectancy-based period of years. But:
1) depending on the size of the IRA, the number of IRA beneficiaries, and the drawdown rate of the IRA by the current owner, the per-beneficiary money may be insignificant at time of eventual distribution. Proactively evaluating this simple math is very informative.
2) The income tax rate of the beneficiaries (often the children, in peak earning yrs) vs. the (presumed elderly benefactor) may actually be higher. Recall that the IRA principle and earnings are income tax DEFERRED, not income tax EXEMPT. Note that we are talking income tax, not capital gains tax
3) the presence of state income taxes may vary between the benefactor / beneficiaries (or consider a more complicated scenario of a beneficiary living overseas!)
4) the actual money involved may not be worth the recurring annual tax preparation effort necessary when compared to the deferred tax benefits.
5) Over time, as an inherited IRA account is drawn down by the beneficiary, it will eventually become so small as to render it difficult to invest / diversify meaningfully. Note that an inherited IRA cannot be comingled with other IRAs you may have; it must be standalone.
6) Alternately, if you (as beneficiary) elect to take a lump sum of your portion of the inherited IRA as taxable income in the year received, you may be escalated into the AMT
Evaluating the strategy: It is relatively easy, using TurboTax, Tax Cut, or other readily available tax prep software, to estimate the federal and state income tax ramifications on the elderly person of gradually moving the various IRA monies into a taxable status over a period of a few years, at a pace greater than the RMD (annual IRA Required Minimum Distribution) to complete the transition from tax deferred to post-tax status. You can then assess the elderly’s incremental income tax rate.
The actual annual transition process from the tax deferred to taxable status can be relatively simple. In my father’s case, we have mutual fund “x” set up as an IRA, and the same mutual fund set up as a taxable account. In January of each year, we send a letter authorizing that an amount of money (always greater than the RMD) be withdrawn from the IRA account and deposited into the taxable account. So his portfolio diversification is unaffected by the tax status transition. In our case, we had $130k to consider, 5 beneficiaries (including 1 overseas, who is not in a position to determine how to handle inherited IRA money), with 2 in high tax brackets, and 4 of the 5 in state with income taxes where Grandpa has none. Compare this top Mark’s example and note the differences.
Note of caution: as the elderly person’s income rises due to the supplemental income from the IRA transition from deferred income to taxable income status, other benefits (Veteran’s benefits, etc) can be impacted.
Big Picture: Recognize that with the federal budget deficit in an untenable condition, tax rates can be expected to increase, and tax laws are likely to be altered in unknown ways to generate tax receipts. Your carefully-crafted financial strategies may be upended in the near future. So IMO, an approach that simplifies an estate settlement and exercises current (known) tax law is preferred over a more complicated approach based on (my perceived) volatile tax law featuring higher rates.
Warning: My homework on this topic took place several years ago. My intention here is to encourage you to consider some concepts, not provide guidance. If you’re not conversant with this topic, or unwilling to dig a bit further to understand / confirm the above (snuggle up with IRS pub 590!), please consult a trusted advisor as Mark wisely recommends.
~Sleepless
Excellent. Your post highlights an issue that I have struggled with in this blog. In trying to make it readable much detail is lost. In trying to make it actionable, much risk is taken. How to balance the possibly conflicting missions?
ReplyDeleteBTW, what is a) your background and b) present employment?
MarkM
Hi Mark - I wholeheartedly agree on the communication challenge of offering a concise and readable post, without crossing the line into giving formal advice. This very challenge is what will make your blog valuable (although I anticipate that the Comments will probably be sparse, as you’ve indicated!).
ReplyDeleteIf nothing else, it makes a statement on the complexity of our expanding tax law, and the degree of integration of different topics that must be addressed to arrive at a comprehensive strategy. Result: It makes it increasingly difficult for those who generate wealth via their labor to legally increase it in a simple, low-risk, low-cost manner.
In the above Comment, the blog software word-counter forced me to trim a bit, so I had to drop a few things. Let me provide one more here, then respond to your A) and B):
Continuation of prev Comment: As a "financial planner" (I use the term here to refer to the activity of financial planning, not to the occupation), recognize that by planning to implement a Stretch IRA, unless you request / receive permission to delve into the finances of all of the beneficiaries, or provide them with an outline of the Stretch IRA vision so they can make a self-assessment, you are unilaterally making financial decisions that may not be in the best interests of some of the IRA recipients. The probability of post-distribution problems occurring will increase with the size of the beneficiary pool (ie, forcing a beneficiary into the AMT, forcing a beneficiary to set up an inherited IRA when they might have preferred the cash instead, etc)
For your A), let me copy / paste from the 1st slide I show when giving an informal presentation on a financial topic:
~
“Warning - I have no recognized “financial” credentials. No CPA, CFA, CMT, CFP, RIA. Relative to this topic, 2/3 of an MBA, and an expired real estate license.
“I’m not a professional in the field (where “professional” is defined as: “participating for gain or livelihood in an activity or field of endeavor often engaged in by amateurs, i.e. a professional golfer”. (Note: you might be better off listening to me vs. professionals, since I am not trying to make a living off you!)
“I DO have a long history of successfully navigating personal finance & markets…. It’s a passion thing.
“DYODD – do your own due diligence. Beware that what I say today may change tomorrow, and I won’t be getting back to you to correct / clarify any impressions. I am not responsible for your investments.
“At some point, most everything I say will be mildly incorrect <-> flat out wrong!
“The objective is to get you to start thinking a bit “outside the box” and to take ownership of your personal finances, vs. a continuation of the “let me tell / sell you what to do” model that is promoted among the financial advisor / mutual fund / business TV crowd.
~
Track Record: 2007 portfolio returns = 18%. For 2008, designed a fully-hedged portfolio for my own assets as the best risk <-> reward strategy for the anticipated credit crunch. Achieved 0% return across the full portfolio, as targeted, with a deviation of less than +/- 10% throughout the yr. Do not use leverage, exotic “financial products”, and am not an active trader. Track record on trades is @ 80-85% successful (because I “let the market come to me”, as Bill would say)
For your B), diverse career path; presently employed as a software development project manager, working on both banking and insurance company financial risk management solutions. Thinking about a career switch to financial planning though…..
~Sleepless
A bit of unsolicited career advice from someone who found out "too late". What ever you read, "play around with", talk about casually with "anyone who will listen", etc is where your heart lies no matter how lucrative your present profession is. You can divide the two, but it usually causes tension. I find that writing about financial planning satisfies my needs to explore finance, psychology, economics, and law. At this point I do not know if it will lead to a position in the industry. At this point it is not necessary that it do so. Therefore, I feel free to speak my mind.
ReplyDeleteBINGO! It is exactly that large-scale, cross-domain integration that I find fascinating. In my case, I'd add "economic history" to your list. Oddly, I don't directly pursue "more money"; that seems to be the natural result of understanding / coordinating the other spheres well.
ReplyDelete~Sleepless