You probably know the basics of establishing the Stretch IRA: name younger beneficiaries, be sure your beneficiary designations are up to date and discuss the Stretch IRA with your beneficiaries.
If so, it’s time for you to consider the next steps to maximize the after-tax value of your IRAs for the next generation.
You want to consider having a custom beneficiary designation form (BDF) or naming a trust as the beneficiary or both. The standard BDFs of most IRA custodians limit the options available to you and your beneficiaries.
You should know, of course, that the BDF controls who inherits your IRAs. Your will or living trust matter only if you name your estate or the trust as beneficiary, and by doing that you lose some valuable tax-deferral potential. You also should know that when a trust is named IRA beneficiary, the power of a Stretch IRA is available only if the trust has special provisions required by IRS regulations that qualify it as a “look-through” trust. See our June 2014 issue for details.
Let’s take a look at some of the key planning issues, how standard forms can hamper you and how a custom BDF or trust can be superior. Some people even say that a custom BDF is a second will.
Unequal beneficiaries. You might want each of your children to inherit a share of your IRA but not equally. One child might be financially better off than the others. Or one or two of the children received more gifts over the years or will receive a larger share of other assets in the estate.
Or you might want to give one beneficiary a specific dollar amount while the others share the rest of the IRA. This might be done when you’re leaving part of the IRA to charity and the rest to your children, as one example.
The default for most IRA custodians is that multiple beneficiaries of an IRA receive equal shares. Some beneficiary forms make it difficult or impossible to state clearly beneficiaries will inherit unequal shares. To be certain of the result you want, it’s a good idea to have your estate planner draft a custom BDF that spells out how much of the IRA each beneficiary inherits.
Predeceased beneficiary. Suppose Max Profits has three adult children. He names them as equal beneficiaries of his IRA. One of the children, Hi, passes away. Max passes before he updates the BDF. The law provides two possible results. If the beneficiary designation is “per stirpes” then Hi’s estate or heirs will inherit his share. If the beneficiary designation is “per capita” then the other beneficiaries will inherit Hi’s share, and Hi’s heirs will be cut out.
If you don’t designate which result you want, the IRA custodian’s default provision controls. Almost all IRA custodians provide that per capita designation is the default. If you want a different result, you need a custom BDF that says so.
Also, under the per capita designation, the remaining beneficiaries can inherit the deceased beneficiary’s share either equally or pro rata (based on their current shares of the IRA). This only matters if these beneficiaries aren’t receiving equal shares, but is very important in that case. Some custodians provide the remaining beneficiaries inherit the deceased beneficiary’s shares equally while others provide for pro rata inheritance. Again, you can change the result with a custom BDF.
The successor beneficiary. Many people want and expect their IRAs to last for more than one generation. But who inherits after your initial beneficiary?
Most standard BDFs don’t allow for the designation of a successor beneficiary. They have a place to designate a contingent beneficiary who will inherit if the primary beneficiary doesn’t survive to inherit the IRA or disclaims the inheritance. But the custodians often don’t provide for designation of a successor beneficiary.
In fact, most of the major IRA custodians don’t allow you to name a successor beneficiary. If there’s a balance in the IRA after the original beneficiary passes away, the custodian’s default provision controls who is successor beneficiary. Most IRA custodians say the estate of the deceased beneficiary is the successor beneficiary. Others provide the surviving spouse of the beneficiary, if any, is the successor beneficiary, and then either the estate or children of the deceased beneficiary.
You also should be aware that if you designate a successor beneficiary, the original beneficiary might be able to change your plans by moving the inherited IRA to a new custodian. Also, some custodians allow the original beneficiary to change the successor beneficiary once the IRA is inherited.
When you want to determine who inherits the remainder of your IRA after the original beneficiary, have your estate planner determine the custodian’s policies. If the custodian provides for designation of successor beneficiaries, be sure to designate one. You might need a custom BDF to make your choice clear.
When a successor beneficiary isn’t allowed by the custodian or you’re concerned the designation might be changed after you pass away, consider designating a trust as the primary beneficiary of your IRA. Your estate planner needs to draft a trust agreement that satisfies the IRS regulations to maintain tax deferral.
Plan for a disclaimer. A disclaimer is when a person decides not to take an inheritance. Sometimes disclaiming inheritance of an IRA is a good strategy. For example, your oldest child might be in a high income tax bracket. It might be better for a family member in a lower tax bracket to inherit the IRA. Or it might make sense for your charitable contributions to be made through the IRA instead of the rest of your estate.
You should work with your estate planner to consider disclaimer strategies that might be smart for your estate and heirs and then incorporate them in a custom BDF. For example, your custom BDF might say that your oldest child will inherit a share of the IRA, but that share will go to a charity if the child disclaims it.
Ensuring the Stretch IRA. Your goal probably is to have your heirs maximize the tax deferral of the IRA by taking out no more than the required minimum distributions (RMDs) for at least a few years. Some IRA owners don’t want their beneficiaries to receive even the RMDs for a period of time. They might have concerns about protecting the money from creditors, the maturity of the beneficiary, or other issues.
A few IRA custodians require beneficiaries to distribute the IRAs within a few years after inheriting them. Most custodians allow beneficiaries a Stretch IRA, taking only the RMDs each year. But only a few custodians allow the original owner to mandate a Stretch IRA by limiting the distributions a beneficiary can take. If a beneficiary wants, the entire IRA can be cashed out right after the inheritance.
To ensure your IRA becomes a Stretch IRA and lasts for years, you need to name a trust as the beneficiary of your IRA and state in the trust agreement how you want the distributions determined over the years.
Designating an investment advisor. A concern of many IRA owners is that the beneficiaries might not invest the IRA well. A Stretch IRA lasts for decades only if the investment returns of the IRA are adequate.
Many IRA custodians allow you give a limited power of attorney to an investment advisor to manage the investments. But you can’t make that binding on the beneficiary. The beneficiary can revoke the power of attorney, designate a new investment advisor, or move the IRA to another custodian.
To ensure the firm or person of your choice manages the IRA, you need to name a trust as IRA beneficiary and designate the investment advisor in the trust agreement.
Beneficiary flexibility. The tax law allows some strategies for inherited IRAs that not all custodians allow. The strategies most likely to be restricted by custodians are splitting an IRA and the portability of an IRA.
Beneficiaries who inherit an IRA together are allowed to split the IRA tax free into separate IRAs for each of the beneficiaries. Splitting the IRA often is a good idea, because the beneficiaries don’t have to argue about investment strategies and distributions greater than the RMDs. Also, when an inherited IRA has more than one beneficiary, the age of the oldest beneficiary is used to determine the RMDs. That’s not fair to younger beneficiaries.
The tax law also allows an IRA to be transferred tax free from one custodian to another. But some custodians don’t allow transfer to other custodians or charge a fee for the transfer.
Check with your custodian to see if these or other strategies are restricted or would incur fees.