Your individual retirement account is a powerful tool to sustain you through retirement. It can also be used to enable your children to benefit from the IRA's tax benefits after your death. The vehicle for doing this is a "stretch IRA."
The term doesn't denote a specific type of IRA, but rather a financial strategy to "stretch out" the life and tax advantages of either a traditional IRA or a Roth IRA.
"A stretch IRA is one designed to stay intact after the death of the IRA owner in order to provide another generation of tax-favored growth," said Tom Murphy, a certified financial planner at Murphy & Sylvest LLC in Dallas.
In other words, "to stretch is to keep your inherited account growing tax-deferred, or tax-free if it's a Roth IRA," said Ed Slott, a CPA and IRA expert.
"It's a massive tax-free transfer of wealth," he said. "You're not giving up anything."
And the best part: All you have to do to set up a stretch IRA for your child is name the child as the beneficiary of your IRA. It's that simple.
But do it on the IRA beneficiary form, not in your will. That's because IRAs pass to your heirs by beneficiary designation.
And the beneficiary must be an individual, Murphy said.
"You can't have the money going to a trust or charity," he said.
Before you jump into a stretch IRA, it's important to understand the rules about required minimum distribution. That's the amount the Internal Revenue Service requires owners of traditional IRAs to withdraw annually from their retirement accounts once they reach age 70{. Owners of Roth IRAs are not required to make annual minimum withdrawals.
Those who inherit an IRA — both the traditional and Roth varieties — must begin taking out the required minimum immediately upon receipt of the IRA, Murphy said. The minimum amount will be based on the person's life expectancy.
So if your 23-year-old child inherited your IRA, he would have to start withdrawing the money immediately and pay tax on it — unless it's a Roth IRA, in which case the withdrawals are tax-free.
"Although distributions are required over the life expectancy of the children who inherit the IRA, the expectation is that the underlying assets will grow at a rate faster than the required distribution," Murphy said.
Here are key questions you need to ask when considering a stretch IRA:
Will you need all of your IRA to live on?
"The best candidate (for a stretch IRA) would be someone whose estate is large enough that there's going to be money left and who has children who are mature enough that they would take the money out over their own life expectancies instead of taking it out all at once," Murphy said.
Even if you think you'll need most of your IRA to live on, a stretch IRA would still be good because you can't predict your death, Murphy said.
"Should your death occur earlier than expected, there could still be significant IRA assets available, even though unplanned," he said.
Murphy likes stretch IRAs for his clients.
"In general, we recommend our clients name individual beneficiaries of their IRAs in order to make the IRA eligible to stretch and almost always recommend the children take only the required minimum distributions when the unfortunate event 1/8the death of their parent3/8 occurs," Murphy said. "This approach maximizes the opportunity to defer taxes, while maintaining flexibility for the children to deal with life's unexpected issues."
How well does your child manage money?
"If the child has difficulty with money, it would be much better for the income tax to be paid at the parent level and the money go to a trust or something where the child cannot get his or her hands on it," Murphy said.
Do you want your IRA money to go to charity or another organization?
"If they want all the money to go to charity, simply name the charity or other organization as the beneficiary," Murphy said. "If the organization is a qualifying nonprofit, all the money can go to it untaxed."
If you want a portion of the money to go to your children and a portion to charity, the best way to do so is to split the IRA into two or more accounts while you're still living and name the children as beneficiaries of one IRA and the charity as the beneficiary of the other, he said.
"Although it is possible to do this with one IRA account, it is fairly complex and there is no assurance the beneficiaries would handle it correctly," Murphy said.
Does your child have special needs?
If so, the better vehicle to use is a special needs trust, which is a legal device that is established to ensure that your child doesn't lose any government benefits.
The purpose of the special needs trust is to manage the family's financial resources while maintaining the child's eligibility for public assistance benefits.
Is your child going through a divorce?
"If there is a high probability of the beneficiary getting divorced, having the income from the IRA being forced out as RMD (required minimum distribution) exposes it to the risk of becoming commingled and then becoming a marital asset," Murphy said.
Then "it's subject to division in divorce proceedings," he said.
The better move is to have the asset go into a trust, with the trust clearly specifying the asset is inherited and therefore separate property and not a marital asset, Murphy said.
Slott says everyone should set up a stretch IRA, particularly those with a Roth IRA because of its tax-free feature.
"The stretch concept is what will turn your retirement savings into the most powerful family wealth-building device available to you," he said.
Source: McClatchy-Tribune Information Services.