Preserving and Transferring IRA Assets

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1 january 2014 Preserving and Transferring IRA Assets Summary The focus on retirement accounts is shifting. Yes, it s still important to make regular contributions to take advantage of tax-deferred growth potential, and it s important to maintain an asset allocation to help you minimize your risk. But for those people nearing or just entering retirement, the focus is shifting from how to build a retirement account to how best to distribute the assets. Whether you are managing your own IRA, choosing your beneficiaries, or dealing with inheritance issues, it s time to start thinking about how to make sure those tax-protected savings are not lost in the tangle of tax and estate issues that can get complicated very quickly in the distribution phase. The Individual Retirement Account ( IRA ) is an asset that poses risks and opportunities, says Jim McCarthy, Managing Director, and Head of Workplace and Investment Solutions at Morgan Stanley. The risk is that funds carefully saved through a lifetime of hard work will be reduced by taxes and poor money management. The opportunity is to promote tax-deferred growth for your retirement and future generations. This document will explain some of the intricacies and show you how to do that.

2 Managing Your Own IRA When you take money out of a Traditional IRA, that withdrawal gets included with your other income for the year and is subject to ordinary income tax (except to the extent the withdrawal represents a return of nondeductible contributions or other aftertax amounts). The longer you leave funds in these accounts, the more tax-deferred growth you can potentially accumulate. How much to withdraw and when You re not required to withdraw money from a Traditional IRA until you reach age 70½, and if you do it before you turn 59½, there s generally a 10% penalty tax on top of any income tax on the funds you take out. There are exceptions for taking an IRA distribution before reaching age 59½ without the 10% premature distribution penalty if it is used for one of several life events or if substantially equal periodic payments are taken. These payments, made at least annually under one of the IRS approved methods and calculated based on life or life expectancy, can be taken at any age for any reason, provided you continue them for five years or until you reach age 59½ whichever takes longer. Most IRA owners wait to withdraw funds until they reach age 70½, when they must start taking required minimum distributions. Although the financial institution can calculate the distribution, you can also figure it out yourself by taking the account balance from December 31 of the prior year and dividing it by the factor applicable to your age (the age you will attain on your birthday in the year in question) listed in the appropriate Internal Revenue Service table. These tables can be found in IRS Publication 590, available online at pub/irs-pdf/p590.pdf. In theory, your IRA has the potential to grow more quickly than other investments because it s not being continually eroded by taxes. You have a choice between taking your first distribution in the year in which you turn 70½ or delaying the first payment until April 1 of the following year, known as the required beginning date. But if you delay, you must take two distributions in the year in which you turn 71½, which can push you into a higher tax bracket. Whether you should withdraw more than the law requires will depend on your finances and your long-term goals. In theory, your IRA has the potential to grow more quickly than other investments because it s not being continually eroded by taxes, says Linda Ward, Executive Director of Personal Retirement Services at Morgan Stanley. But McCarthy suggests considering a different strategy for people with a net worth of $25 million or more. In general, they should consider drawing down their retirement accounts before spending other assets either by withdrawing the funds themselves, or by giving them to charity. McCarthy reasons that retirement assets, which tend to comprise just a small portion of the balance sheet of high net worth people, are among the most encumbered and difficult ones to estate plan with. What s more, since funds coming out of these accounts are taxed as ordinary income, you don t get the benefit of the lower tax rates that apply to dividends and capital gains, he says. On the other hand, the tax law now provides opportunities for people who have deferred taking tax-efficient withdrawals. For example, as of January 1, 2010 IRA owners can convert a Traditional IRA to a Roth IRA regard-less of their income. With time, we may also see more generous provisions for lifetime gifts of IRA assets to charity. John Picone, Managing Director of Annuity and Insurance Products at Morgan Stanley, points out that recent innovations in the product design of annuities provide individuals with significant flexibility in managing IRA distributions. Many annuity benefits can maximize the amount of income available to clients, as well as protect one s principal, regardless of the underlying performance of the financial markets. Investing IRA assets When IRAs comprise a larger portion of your net worth, you need to look more closely at these accounts in the context of your risk tolerance and total asset allocation. No matter what the investment, withdrawals of taxable amounts from Traditional IRAs will be taxed as ordinary income, so you won t have the benefit of the lower tax rates on dividends and capital gains, or the ability to offset capital gains against losses. But if you invest some of your IRA in stocks, you have the potential to achieve more growth, even after taxes, than you would with lower-paying fixed-income investments, Ward says. 2 Morgan Stanley 2014

3 Many people will inherit an IRA from a parent or spouse. The strategies that surround these IRAs involve extending the period over which inheritors must take distributions. With a longer payout period, inheritors can reduce the amount of required minimum distributions which can reduce taxes and let the IRA maintain tax-deferred growth potential. Since inheritors, who are designated beneficiaries under the IRA, are generally able to take withdrawals based on their life expectancy under IRS tables, the younger the beneficiary, the longer the payout period. Spousal rollovers A spouse assume it s the wife who inherits an IRA has a choice of whether or not to roll over that IRA into one she already owns. There are two advantages to rolling over the IRA to her own IRA. One is that it enables her to postpone taking distributions until she is 70½. The other advantage of this strategy is that the life expectancy table she would use to figure her required distributions would result in a longer payout period than the one that would apply if she remains as the beneficiary of her husband s IRA. For example, assume a 70-year-old wife inherits her husband s IRA after he dies at age 70. If she leaves it in her husband s name, she must take annual required distributions, starting the year after her husband s death, over her life expectancy. At age 71, her life expectancy is 16.3 years, according to The Single Life Expectancy Table (for use by Beneficiaries), so she must withdraw about 1/16 of the IRA. Although her life expectancy will be recalculated each year based on her new attained age (so the IRA balance never goes to zero), the IRA would be substantially depleted by the time she reaches her late 80s. And after her death, her remainder beneficiaries would have to withdraw all remaining funds from the account over the remainder of the wife s life expectancy at her death. Handling an Inherited IRA In contrast to this scenario, if the 70-year-old wife rolls over the IRA she inherited from her husband after he died at age 70, the assets have the potential to grow tax-deferred for a much longer period of time. In that case, her annual required distributions are computed using the Uniform Lifetime Table. Thus, the first year s withdrawal will be about 1/27 of the account. With the rollover, the account will not even start to shrink below its value at age 70 until the wife reaches age 90. (That assumes a hypothetical 6% investment return, not representative of any particular investment, and assumes she takes out no more than the minimum required.) Then, at her death, she can leave her IRA to the next generation, who can utilize the stretch-out option over one of their own life expectancies after her death. So generally, for a surviving spouse, the spousal rollover can be a better choice than leaving the assets in the deceased spouse s name and taking them as beneficiary. However, if a surviving spouse less than 59½ needs to withdraw from the account, she might want to delay doing the rollover to her own IRA until after she reaches age 59½, to avoid the 10% penalty tax. Inherited IRA accounts A beneficiary other than the surviving spouse (such as a child of the deceased IRA owner) does not have the option to roll over the inherited benefits to his own IRA. However, he can hold the IRA as an Inherited IRA. The inheritor must begin taking distributions by December 31 of the year following the IRA owner s death, and can generally stretch them out over his life expectancy (applies to IRAs only). In addition, a non-spouse beneficiary can direct the trustee of another type of inherited plan (such as a 401(k)) to transfer the inherited benefits directly into an Inherited ( beneficiary controlled ) IRA account. In this case, the inheritor's distribution options will depend in part upon the terms of the plan from which the account was inherited. To avoid paying income tax on the entire IRA right away, the account title must include the name of the person who left the funds. For example: John Doe, deceased, IRA payable to Junior Doe as beneficiary. As of January 1, 2010, IRA owners can convert a Traditional IRA to a Roth IRA regardless of their income. Morgan Stanley

4 Most married people start by naming their spouse as beneficiary. Although that s a natural inclination, it may not be the most tax-efficient option. Splitting accounts for co-beneficiaries When multiple people are beneficiaries for a single IRA account, it s a good idea to split the distribution into separate IRAs. All beneficiaries would get the same share they were entitled to under the beneficiary designation form, but could take distributions over their own life expectancies. You will need to take this step before December 31 of the next year following the IRA owner s death. If you don t, the payout schedule is based on the life expectancy of the oldest beneficiary. The stretch-out option The stretch-out option allows designated beneficiaries of Inherited IRAs to name their own beneficiary, known as the remainder beneficiary. Remainder beneficiaries may continue to receive required distributions after the deaths of both the IRA owner and the original designated beneficiary. The remainder beneficiary continues to receive required distributions based on the nonrecalculating (term certain) method until the payout term is finished. The stretch-out option is not meant to increase the total number of years over which IRA payments are made it is meant to continue the designated beneficiary s payout schedule. The stretch-out option is utilized primarily by non-spouse beneficiaries who can not roll over Inherited IRAs to their personal IRA. Disclaiming an IRA inheritance Beneficiaries who don t need the money or who want to do some estate planning of their own, can disclaim (decline) the inheritance. This may permit their share of assets to pass to younger beneficiaries, who can achieve a longer stretch-out. Depending on how the beneficiary designation form is drafted, disclaimed IRA assets can go to either a co-beneficiary, a contingent beneficiary or the owner s children through a per stirpes distribution inheritances passed down the branches of a family tree rather than to other members of the same generation. Beneficiaries must work within these parameters when deciding whether to disclaim it s not totally up to them where the money should go. Whenever you disclaim an IRA inheritance, there are several caveats. Generally a disclaimer must be made within nine months of the IRA owner s death, and the person disclaiming the inheritance may not have accepted an interest in the asset or any of its benefits. An innocent mistake like changing the way an IRA is invested could taint the disclaimer. When disclaiming property down a generation in order to benefit the grandchildren of someone who has died, generation-skipping transfer taxes may apply, on top of any estate tax if death occurred after Estate tax deduction A beneficiary who inherits an IRA from an estate subject to federal estate tax is entitled to an itemized income-tax deduction for the estate taxes attributable to the IRA (determined by an IRS formula). The deduction applies regardless of who actually paid that estate tax. You can only use the deduction to offset funds withdrawn from the IRA in a given year. This important and often overlooked deduction can be spread out over future tax years until it is used up. 4 Morgan Stanley 2014

5 Money in an IRA usually passes outside of the owner s will and is distributed according to beneficiary-designation forms filled out when people open the accounts. (The beneficiaries can be amended at a later time.) Who you name as beneficiary determines who gets the money after you die and how quickly your heirs must withdraw it. Keep in mind that most IRA custodians have default beneficiary provisions built into their plan documents that will apply if there is no beneficiary designation on file. For example, a common default provision provides that if the IRA owner doesn t designate a beneficiary or all beneficiaries predeceases the IRA owner or disclaim their interests the beneficiary will be the surviving spouse or, if none, surviving children in equal shares or, if none, the IRA owner s estate. Given the importance of the beneficiary designation forms in disposing of your assets, it s important to have them reviewed by a legal and / or tax advisor who is knowledgeable about the rules that apply to IRAs, and to integrate it with the rest of your estate plan. Even so, there s often a disconnect between what the saver of the money and the eventual beneficiary expect to do with it, McCarthy notes. Most [inheritors] would have a great deal of difficulty not dissipating the money. The type of IRA beneficiary most likely to take advantage of the stretch IRA (life expectancy payout) is an adult with a good job, who has a family, owns a home and is trying to save for his or her own retirement. An Inherited IRA gives a big boost to their retirement savings, which is usually the biggest gap in their life, says McCarthy. Choosing IRA Beneficiaries Balancing tax concerns with family needs Most married people start by naming their spouse as beneficiary. Although that s a natural inclination, it may not be the most tax-efficient option. For stretch-out purposes, the stretch-out may be longer if you named a child or grandchild. However, if the beneficiary is a minor, a guardian would have to be appointed to receive the funds. Naming a beneficiary other than your spouse also makes sense from an estate-planning perspective. If your spouse inherits the IRA, there s no federal estate tax at that point because of an unlimited marital deduction. But if those assets continue to appreciate there could be substantial federal estate taxes when they pass to the next generation. It is important to note that you should consult with your tax and legal advisors about the potential effects of your state's community property laws, if any. Contingent and disclaimer beneficiaries In addition to choosing the primary beneficiary, it s also important to select contingent beneficiaries. Your contingent beneficiaries receive the IRA if the primary beneficiary either dies before you or disclaims the inheritance. Disclaimers will be limited by the terms of the beneficiary form the primary beneficiary cannot designate who will receive the IRA benefits. If there is no contingent beneficiary named and the primary beneficiary disclaims, the assets may be distributed pursuant to the IRA s default provisions. If distributed to the estate, it could have very disastrous income tax consequences. Designating a trust as beneficiary You might be inclined to name a trust as an IRA beneficiary for all the same reasons that you would use a trust in other contexts: to protect assets from creditors, to provide for children who are minors or have disabilities, or to control the cash flow of spendthrifts. (The trust can essentially force them to take advantage of the stretchout option.) When there are compelling reasons to name a trust, it s crucial that it qualify as a designated beneficiary. Only then will the IRS look through it and treat its beneficiary as if he or she were directly named as the IRA s beneficiary. This enables the trust to take advantage of the favorable minimum distribution rules that apply to individual beneficiaries. There are a couple of potential pitfalls. One is that even if the trust qualifies as a look-through (or seethrough) trust, the stretch-out may be significantly shorter than you would have liked. This could happen if, in a trust with multiple beneficiaries, one is much older than the others. Since Morgan Stanley

6 the payouts must be based on the life expectancy of the oldest trust beneficiary, that shorter payout period will apply for the younger ones as well. Another risk of naming a trust is that you may choose trust beneficiaries that prevent the trust from qualifying as a designated beneficiary. This problem commonly arises when people name their estates or a charity as the beneficiary of a trust, which in turn is the beneficiary of the IRA. Since neither is a human being, the trust does not qualify as a designated beneficiary. For example, a trust that says, "distributions to my wife will be made in the discretion of the trustee for her support, health and maintenance for life, the remainder to the church," generally won t qualify for favorable treatment. In such cases, the trust will still get the money. However, it may be required to take the payout within as little as five years, if the account owner hadn t reached the required beginning date. A different payout period applies if the owner died on or after this date. In that case a trust without designated beneficiary status can calculate withdrawals according to the account owner s remaining life expectancy, as if he or she were still alive. This would probably mean a more rapid payout than if the trust could use the life expectancy of the oldest beneficiary to calculate withdrawals. One more caveat: it s generally much more tax-efficient to leave an IRA to your spouse outright than through a trust. Here, too, the difference turns on the IRS tables used to calculate distributions. The extremely favorable table that applies to spousal rollovers can t be used in this context. In calculating distributions based on the wife s life expectancy, the trust would have to rely on the table that applies to all other inheritors. Naming a charity as a beneficiary If you want to leave IRA assets to charity, there are ways to do this without involving a trust, and good tax reasons for doing so. Most notably, it avoids the two taxes that apply when people inherit IRA assets income taxes and estate taxes which together could consume up to 65% of a family s IRA inheritance. In contrast, a charity, which is tax-exempt, can draw the funds without paying income tax, and the estate can take a charitable deduction for the amount left to charity. Given a choice about how to divide up the assets in their estates, many people who are philanthropically inclined therefore find it more tax efficient to give the IRA to charity and leave their heirs other property. The simplest way to make the gift is by directly naming the charity in the IRA beneficiary designation form. You can either make the charity a 100% beneficiary of the IRA, or indicate that the charity is a beneficiary of a certain percentage of the IRA, and that the rest should go to individual beneficiaries. You have a wide range of choices when choosing the charitable entity to receive the IRA gift. It can be any organization that you could make a gift to and take a charitable deduction from income taxes, including: a private foundation, a public charity, a supporting organization, a community foundation or a donor-advised fund. Contact Your Morgan Stanley Financial Advisor Your retirement savings may be the primary source of your income when your retire. Your Financial Advisor can offer you strategies and guidance to help successfully manage your income in retirement and preserve the wealth you ve accumulated for yourself and your heirs. your morgan stanley financial advisor is committed to helping you prepare for the future. 6 Morgan Stanley 2014

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8 Asset allocation does not assure a profit or protect against loss. The value of equity securities may fluctuate in value and may be worth more or less than their original cost. Annuities are offered in conjunction with Morgan Stanley s licensed insurance agency affiliates. If investing in an annuity through a tax-advantaged retirement plan such as an IRA, you will get no additional tax advantage from the annuity. Under these circumstances, you should only consider buying an annuity because of its other features, such as lifetime income payments and death benefits protection. Taxable distributions (and certain deemed distributions) from an annuity are subject to ordinary income tax and, if taken prior to age 59½, may be subject to a 10% federal income tax penalty. Withdrawals are subject to plan provisions and, if made before age 59½, may be subject to a 10% federal tax penalty. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not fiduciaries (under the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise provided in a written agreement with Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are encouraged to consult their tax and legal advisors regarding any potential tax and related consequences of any investments made under an IRA Morgan Stanley Smith Barney LLC. Member SIPC. PS CRC /14 CS /14