How to Beat the Tax On Your IRA

How much of your IRA will make it to your heirs? If you are like most people, your IRA is your most valuable asset. But by the time it reaches your heirs, it will be worth less than one half what it is now. Estate taxes will take the first chunk out of the IRA. Then income taxes will grab another giant slice. (Yes, your heirs have to pay income taxes as they receive money from the IRA.)

To make matters worse, most IRAs are required to be distributed quickly after they are inherited. It doesn’t matter if your heirs don’t need the money yet. They have to give up the tax deferral and take the taxable income.

But it doesn’t have to be this way. With a little planning, you and your spouse can ensure that your heirs get maximum value out of your IRA. Even better, big IRA sponsors, such as Schwab and Fidelity, recently changed policies so it is easier to preserve an IRA for generations.

You are required to take a minimum distribution from the IRA each year starting by April 1 of the year after you turn age 70½. Fail to take the distribution, and you’ll pay a penalty equal to 50% of the missed distribution.

But don’t wait until you are age 70½ before setting your distribution schedule. Because teh minimum distribution schedule also determines how much of your IRA gets to your heirs. That’s why it should be part of your estate planning.

You have choices for computing the minimum distributions. Once you begin the required distributions, the formula is locked in. There are two key decisions that determine the required distributions.

The first decision is the choice between the term certain and recalculation method of computing your life expectancy. Required minimum distributions are computed by dividing your life expectancy into your IRA balance on the previous year’s Dec. 31. Your life expectancy is determined from tables provided by the IRS. Under the fixed term method, your life expectancy is determined the first year you compute required minimum distributions. After that, your life expectancy is the previous year’s expectancy minus one.

You can see that using the fixed term method ensures that your IRA is exhausted by the end of your original life expectancy, even if you aren’t. To avoid that, under the recalculation method your life expectancy is redetermined annually. Each year you live extends your life expectancy, and that ensures required minimum distributions won’t make you outlive the IRA. (The recalculation method can be used only if your spouse is the beneficiary.)

But there’s a hidden trap in the recalculation method. Under the fixed term method, the distribution schedule is fixed. If you die, the beneficiary or estate takes distributions on the same schedule established during your lifetime. But under the recalculation method, your life expectancy is zero the year after your death and the beneficiary must take a distribution of the entire IRA that year. The only exception is when the beneficiary is your spouse, has outlived you, and elects to rollover the balance to a new IRA and start the process over.

The recalculation method is great if the beneficiary is your spouse and your spouse outlives you. Otherwise, it causes problems. That’s why your best bet might be not to gamble on the ideal scenario. Instead, choose the fixed term method.

There is a third method, known as the hybrid method, that not too many financial advisers know about but that clearly is allowed by the IRS regulations. This method makes it impossible for you to outlive the IRA and does not force a distribution after your death. Your life expectancy is computed using the recalculation method, and the fixed term method is used to compute your beneficiary’s life expectancy. The two life expectancies become the joint life expectancy. The method is best used when your spouse will need to inherit the IRA and you want to hedge against your outliving the beneficiary.

The second decision is your choice of beneficiary. If your spouse will need the IRA to meet his or her living expenses, then your spouse needs to be beneficiary. Otherwise, consider naming another beneficiary. Or split the IRA with different beneficiaries for each new IRA.

This strategy les you compute the required minimum distribution schedule using the joint life expectancy of you and the beneficiary. Selecting a child or grandchild as beneficiary reduces the required annual distributions and makes the IRA last longer. If the beneficiary is more than 10 years younger than you, the joint life expectancy is computed assuming the beneficiary is only 10 years younger.

After your death the beneficiary must continue taking required distributions each year. But the beneficiary can set a new distribution schedule using only his or her life expectancy. That can set the IRA on a new schedule that will allow it to last for decades. That’s why naming a child or grandchild as beneficiary of the IRA is known as the Stretchout IRA. It allows your beneficiary to tax advantage of the IRA’s tax deferral until he or she is ready to retire.

In the ideal scenario, you name your spouse as beneficiary and use the recalculation method to compute required minimum distributions. Your spouse outlives you and rolls over the IRA into a new IRA, selecting a child or grandchild as beneficiary and computing the required minimum distributions using the new joint life expectancy. Then the child or grandchild recomputes the required distributions using only his or her life expectancy.

But you cannot count on the ideal scenario. So you might want to consider some of the options mentioned here, such as using the fixed term method or naming someone other than your spouse as benefciary.

Major IRA sponsors are making it easier for you to take advantage of these strategies. Until recently, many mutual funds and brokers required beneficiaries of an inherited IRA to take a distribution of the entire amount in the year after the original owner’s death. That resulted in unnecessary taxes. Often after estate and income taxes, beneficiaries walked away with less than half of an IRA’s value. Vanguard, Salomon SmithBarney, and some others always allowed tax deferral of inherited IRAs. Recently, TIAA-CREF, Schwab, and Fidelity announced that they would change policies and allow you to use these IRA strategies. T. Rowe Price still requires immediate distribution of an inherited IRA.

Not all IRA sponsors know about these strategies, and the “frontline” people who work with customers often aren’t familiar with them. Don’t be afraid to ask for someone with specialized knowledge of IRAs. Many IRA sponsors have retirement plan specialists. More details about IRA strategies are in the Fifth Edition of my Retirement Tax Guide, including a series of questions to ask IRA sponsors (800-552-1152: $45).