Making Stretch IRAs Easier, While You Can

The Stretch IRA is the Holy Grail for many IRA owners. They want their IRAs to last a long time. They want the magic of time and tax deferral to boost the IRA balance. These IRA owners have adequate income and resources, so they don’t plan to spend down their IRAs. They expect the IRAs to last their lifetimes and help fund their children’s retirements and maybe their grandchildren’s early adult years.

It’s a tall order, but the goals are achievable. In fact, they are easier to achieve than in the past, because of changes the IRS made in the early 2000s. There are efforts in Washington to curtail Stretch IRAs, but for now these strategies work. Yet, both the IRA owner and beneficiaries have to take certain actions.

Discuss your goals with your beneficiaries before trying to create a Stretch IRA. Explain to them why you think it is a good idea and what they would have to do to ensure a Stretch IRA.

You want to talk to the beneficiaries first, because IRA sponsors report that the vast majority of IRA beneficiaries simply distribute the full IRAs after inheriting them, pay the taxes, and spend the after-tax amount. I suspect most IRA beneficiaries don’t know their options. You, or your financial advisor, should explain the choices they have and why you’d like them to have a Stretch IRA.

Your first step is to name one or more individuals as primary beneficiaries of the IRA. In general, when non-individuals (such as your estate or most trusts) are named a primary beneficiary, or no beneficiary is designated, the entire IRA must be distributed within five years of the your passing. There’s an exception for a certain type of trust described in our June 2014 visit, but otherwise you can’t have a Stretch IRA when no beneficiary is named or you name the estate, a corporation or other entity, or a nonqualifying trust.

Remember your will and living trust have no effect on who is an IRA beneficiary. The beneficiary designation form filed with the IRA custodian controls who is considered the beneficiary or beneficiaries.

You don’t have to name a specific individual. You can name a category of identifiable people, such as “my children.” But it is better to name specific individuals.

You also should designate contingent beneficiaries. These are individuals who will inherit the account if the primary beneficiaries either are deceased or disclaim the inheritance. Only those people named as primary or contingent beneficiaries on the beneficiary designation form will be eligible to inherit.

When multiple beneficiaries are named, each must be an individual or a qualifying trust and it must be possible to determine the oldest member of the group.

For most IRA owners, the choice of primary beneficiary is automatically the spouse. Contingent beneficiaries often are automatically the children.

An IRA owner who wants to ensure a Stretch IRA and maximize planning possibilities, should appoint several levels of beneficiaries. For most IRAs, the appropriate listing is for the spouse to be primary beneficiary with the children or a qualified ira trust as contingent beneficiaries. Some people skip a generation and name the grandchildren as contingent beneficiaries. Otherwise, the grandchildren are named as a second level of contingent beneficiaries. Some advisors recommend naming a charity or family foundation as a last resort final contingent beneficiary in case everyone already named isn’t able to inherit.

Of course, you don’t have to follow the standard recommendation. Each owner has different loved ones and interests. The goal is to ensure an individual or charity will be the beneficiary. Otherwise, your estate will be the beneficiary, and the IRA will have to be emptied and taxed within five years.

After the IRA owner passes, the IRA administrator determines the Designated Beneficiary, a concept introduced by the IRS in 2001 and 2002 regulations. The DB is selected from the primary or contingent beneficiaries. The DB must be determined by Sept. 30 of the year following the year of the account owner’s death. The main significance of the DB is that his or her age is used to determine the required distributions, and the oldest primary beneficiary usually is the DB. If there is no DB, a Stretch IRA is not possible, which is why you name all those primary and contingent beneficiaries.

The beneficiary (or beneficiaries) must be sure to have the IRA titled as an inherited IRA and not make the mistake of having it rolled over to their own IRAs or distributed to them. This is discussed in more detail in my report, Bob Carlson’s Guide to Inheriting IRAs, which is available through the Bob’s Library tab on the web site at www.RetirementWatch.com.

When multiple beneficiaries inherit, they have the option to split the IRA in a tax-free transaction into separate IRAs for each of them. Once an inherited IRA is split into separate IRAs, each beneficiary can use his or her own age to compute the required distributions. Separation also allows each beneficiary to make his own investment and distribution decisions.

There are several requirements for a valid, tax-free separation of an IRA.

First, all post-death earnings, gains, losses, and contributions of the IRA must be shared pro rata between the different IRAs. Because of difficulties in computation, it is best for the heirs to split the IRA soon after the inheritance.

Second, the separate accounts must be established by December 31 of the year after the year in which the owner’s death occurred. This also is the deadline for taking the first required distributions from an inherited IRA. The separation can occur any time in the year of the owner’s death or in the following year.

As a practical matter, since the RMDs must be taken by Dec. 31 of the year following the year of the owner’s death, the separation of the IRAs should occur sooner so that the distributions can be computed and taken. In addition, the DB must be determined by September 30 of the year after the year of the owner’s death. These are additional practical reasons for the split to occur sooner rather than later.

Beneficiaries still may split an IRA after the initial deadline passes. But there are limits and complications for late split. The required distributions for each IRA after the late separation must be computed using the life expectancy of the oldest beneficiary of the IRA before the separation. Another way of saying that is each separate IRA must continue using the required distribution schedule of the original joint IRA. Also, income and gains that have accumulated since the original owner’s death must be split pro rata among the different IRAs.

Issues for the Next
Generation Inheritance

It is possible that the initial beneficiary of a Stretch IRA will not live to see the account depleted. The required distribution calculation method is designed so that the account will not be empty when the beneficiary reaches the original life expectancy. So, what happens after the initial beneficiary passes away?

After the initial beneficiary dies, the legal rights to the account pass to a successor beneficiary. The successor beneficiary must keep the same distribution schedule and method the initial beneficiary had. The successor will compute the distributions assuming that the initial beneficiary lived.

There’s some controversy over who becomes the successor beneficiary. The most-accepted interpretation seems to be that the original beneficiary names the successor beneficiary or beneficiaries. If the original beneficiary failed to designate a successor beneficiary, then the beneficiary’s estate is the successor beneficiary.

There’s an exception if the IRA is the less-common trusteed IRA (see our June 2014 visit for details). With a trusteed IRA, the original IRA owner can designate the primary, contingent, and successor beneficiaries. But in the frequently-used custodial IRA, that’s not the case.

The terms of the custodian’s IRA plan documents or state law could change the succession order, but in most cases the beneficiary names the successor beneficiary or the beneficiary’s estate becomes the successor.

Because of these rules, it is important for a beneficiary to name one or more successor beneficiaries soon after inheriting. Otherwise, the Stretch IRA won’t be maximized.

Note that the original contingent beneficiaries are out of the picture once someone takes ownership of the IRA as a beneficiary. You don’t control who inherits your IRA after your initial beneficiary. The beneficiary determines who finally inherits the IRA. That’s one reason some people want to name trusts as their IRA beneficiaries.

The situation is a little different when the surviving spouse was the initial beneficiary. A surviving spouse has the option to roll over the inherited IRA to a new IRA in his or her name. This is known as a “fresh start” IRA. This IRA is operated without reference to the original IRA. The surviving spouse names new beneficiaries and contingent beneficiaries and takes required distributions based on his or her age. The original owner has no say in the ultimate beneficiaries.

RW February 2016.