Overcoming Hurdles to Stretch IRAs

Making IRAs last a long time, especially for heirs, is a prime goal of many IRA owners. Hurdles stand in the way. Required mini-mum distributions after age 70½ force them to withdraw more from their IRAs each year than they need or want to. The forced distributions trigger higher income taxes. Then, the heirs can make mistakes after inheriting the IRA or simply decide they want to spend all of it right away.

Family dynamics also can be an issue. Most people name their spouses as primary beneficiaries of their IRAs, with their children as contingent beneficiaries. But your children won’t receive any of the IRA if your spouse decides to spend it. A spouse also might rollover an inherited IRA to a new IRA and name new beneficiaries. Some people are concerned the surviving spouse might leave the IRA to children from a previous marriage or a spouse and children from a subsequent marriage.

An obstacle on the horizon to bear in mind is the proposal to end the Stretch IRA that allows inheritors of IRAs to take minimum distributions based on their life expectancies. This allows an inherited IRA to last for decades. The proposal from the President and others would require inherited IRAs to be distributed and taxed within five years.

In addition to these issues, income taxes are a steady drain throughout the IRA’s life.

There’s a strategy that overcomes these hurdles and is especially attractive to charitably-minded people.

You create a charitable remainder trust and name it as the primary beneficiary of your IRA. The terms of the trust are that it will pay income to your spouse for the remainder of his or her lifetime, and then it will pay income to your children for the remainder of their lifetimes. After the last child passes away, the amount remaining in the trust goes to one or more charities you named in the trust.

After you pass away, the IRA balance is immediately distributed to the trust. Because this is a charitable trust, there are no income taxes on the distribution. The trust receives and can invest the full balance.

You set the income payouts to the beneficiaries when creating the trust, within limits set by the IRS. The general rule is that the payouts must be set so that it is estimated that the charity will receive at least 10% of the initial balance. Usually this means that the beneficiary can receive a maximum of 4% to 5% of the trust balance annually. But this depends on the age of the trust beneficiaries. If you have young children or grandchildren as beneficiaries, lower payout ratios might be required. This is something your estate planner has to determine.

The IRA is included in your taxable estate. The estate receives a deduction for the present value of the charities’ share of the trust and the rest is potentially taxable.

When distributions are made to your spouse and children from the trust, those will be subject to income taxes. The amount of the taxes will depend on whether the trust is distributing income, capital gains, or principal.

The result is that you’re ensured the IRA balance will last for many years to benefit both your surviving spouse and your children, and perhaps beyond. They’ll receive steady streams of income for their lives. In addition, you’ve provided a benefit to one or more charities of your choice.

The downside, especially to the beneficiaries, is that they can’t tap the trust for higher payouts. They don’t have access to or inherit the principal. They receive only the stream of income. There’s also the possibility that poor investment returns will cause the trust to run out of money during their lifetimes, though that should be a low probability.

Setting up the charitable remainder trust will cost more money than simply naming a beneficiary of an IRA, so it doesn’t make sense to use this strategy with small IRAs.

Individuals with sizeable IRAs who are concerned about the steady drain of income taxes from their IRAs and worry that the IRAs won’t benefit their families for as long as they could, should consider combining a charitable remainder trust with their IRAs.

RW August 2014.