Extending Retirement Assets: A Stretch IRA Review Are you interested in the possibility of using the funds in your traditional IRA to provide income to one or more generations of family members? Table of Contents Page What Is a Stretch IRA? 2 How Are Required Minimum Distributions Calculated? 2-3 Other Traditional IRA Minimum Distribution Requirements 3-4 What Is the Impact of Lifetime Requirement Minimum Distributions? 4-5 Naming an IRA Beneficiary 5-6 What Happens at a Traditional IRA Owner s Death? 6-8 Stretch IRA in Action: Spouse as Beneficiary of Traditional IRA 8 Stretch IRA in Action: Non-Spouse as Beneficiary of Traditional IRA 9 IRAs and Bankruptcy Protection 9-10 Stretch IRA Advantages and Disadvantages 10 Important Information 11
What Is a Stretch IRA? A major benefit of an IRA is that there is no federal income tax paid on the growth in the IRA until, that is, the funds are actually distributed, at which time income tax must be paid on the amount of the distribution from a traditional IRA. Over a period of years, this tax deferral can contribute to the accumulation of significant funds in an IRA. Traditional IRA tax deferral, however, cannot continue indefinitely. Federal tax law requires that distributions from a traditional IRA must begin no later than April 1 of the year following the year in which the IRA owner reaches age 70-1/2, whether or not the IRA owner has retired. What if the owner of a traditional IRA has sufficient retirement income and, rather than taking IRA distributions, would prefer to leave the IRA to his or her heirs? If the owner of a traditional IRA has sufficient retirement income without the need to take IRA distributions above the required minimum distributions, a "stretch" IRA might be the answer. A "stretch" IRA is not a special type of IRA instead it is a wealth planning strategy with the objective of stretching the amount of time during which traditional IRA assets have the opportunity to continue growing on a tax-deferred basis inside of the IRA. How Are Required Minimum Distributions Calculated? IRS regulations include a "Uniform Lifetime Table" that is generally used to calculate the required minimum distributions that must be made from traditional IRAs beginning at age 70-1/2. To calculate your annual required minimum distribution, follow these simple steps: Step 1: Account balance as of the previous December 31: Example: $ $200,000 Step 2: Distribution period factor based on age as of December 31 in the year for which the distribution is being calculated (see next page): 25.6 Step 3: Divide Step 1 by Step 2; the result is the annual required minimum distribution for the current year: $ $7,812.50 Stretch IRA Review Page 2 of 11
Age Distribution Period Factor Uniform Lifetime Table Age Distribution Period Factor Age Distribution Period Factor 70 27.4 86 14.1 102 5.5 71 26.5 87 13.4 103 5.2 72 25.6 88 12.7 104 4.9 73 24.7 89 12.0 105 4.5 74 23.8 90 11.4 106 4.2 75 22.9 91 10.8 107 3.9 76 22.0 92 10.2 108 3.7 77 21.2 93 9.6 109 3.4 78 20.3 94 9.1 110 3.1 79 19.5 95 8.6 111 2.9 80 18.7 96 8.1 112 2.6 81 17.9 97 7.6 113 2.4 82 17.1 98 7.1 114 2.1 83 16.3 99 6.7 115 and older 1.9 84 15.5 100 6.3 85 14.8 101 5.9 EXCEPTION: If your beneficiary is your spouse who is more than 10 years younger than you, instead of this table you can use the actual joint life expectancy of you and your spouse from the IRS Joint and Last Survivor Table to calculate required minimum distributions. NOTE: Non-deductible Roth IRAs are not subject to minimum distribution requirements. Other Traditional IRA Minimum Distribution Requirements When Must Required Minimum Distributions Begin? Required minimum distributions must begin no later than April 1 of the year following the year in which you reach age 70-1/2 and must continue each year thereafter. If you wait until the year following the year in which you reach age 70-1/2, you must receive a minimum distribution on behalf of the previous year by April 1 of the current year, and a minimum distribution on behalf of the current year by December 31 of that year. What Happens if Minimum Distribution Requirements Are Not Met? If the amount distributed from a traditional IRA is less than the minimum distribution required in any calendar year, a penalty tax equal to 50% of the amount by which the actual distribution falls short of the required minimum distribution is imposed. For example, if the required minimum distribution for a calendar year is $20,000, but only $12,000 is actually distributed from the IRA, a penalty tax of $4,000 must be paid ($20,000 - $12,000 = $8,000 x 50%) an outcome to be avoided! Stretch IRA Review Page 3 of 11
Are There IRA Reporting Requirements? Yes, financial institutions must report IRA required minimum distribution amounts to the IRS. NOTE: Traditional IRAs have minimum distribution requirements during the owner's lifetime. Roth IRAs, on the other hand, have no date by which distributions must begin during the owner's lifetime. Both have distribution requirements that come into effect at the IRA owner's death. What Is the Impact of Lifetime Required Minimum Distributions? The objective of the required minimum distribution rule is to ensure that the entire value of a traditional IRA will be distributed over the IRA owner's life expectancy. Basing distributions on life expectancy, however, allows required minimum distributions to be spread over a significant number of years, during which the assets remaining in the IRA continue to grow on a tax-deferred basis. Let's look at an example. Assuming the IRA account balance is $500,000 when required minimum distributions must begin and the account owner is age 71, the following is the impact on the IRA account balance of taking only the required minimum distribution each year, assuming the remaining account balance earns 5% (1) and that the required minimum distribution is taken on December 31 of each year. Year Beginning IRA Balance (2) Age Ending IRA Balance (3) Required Minimum Distribution (4) 1 $500,000 71 $525,000 $18,868 2 506,132 72 531,439 19,771 3 511,668 73 537,251 20,715 4 516,536 74 542,363 21,703 5 520,660 75 546,693 22,736 10 527,542 80 553,919 28,211 15 504,875 85 530,119 34,113 16 $496,006 Total Distributions: $392,624 See next page for footnotes. Stretch IRA Review Page 4 of 11
(1) (2) (3) (4) For illustration purposes only; is not indicative of the actual performance of any particular investment and does not reflect the fees and expenses associated with any particular investment, which would reduce the performance shown in this hypothetical illustration if they were included. In addition, rates of return will vary over time, particularly for longer-term investments. As of December 31 of the previous year, after subtracting that year's required minimum distribution As of December 31 of the current year Assumes that the required minimum distribution is taken on December 31 of each year While this is a hypothetical example, it does illustrate how a traditional IRA can continue to grow in value, despite the payment of required minimum distributions. In our example, the IRA owner receives over $392,000 in distributions through age 85, at which point the IRA value first drops below its original value of $500,000. It is important to understand, however, that IRA income and growth is dependent on the actual rate of return of the underlying investments that fund the IRA, as well as the length of time the money is invested rates of return vary over time, particularly for long-term investments. Naming an IRA Beneficiary When you open an IRA account, you are asked to name a beneficiary or beneficiaries to receive the value of the IRA at your death. You can also change beneficiaries during your lifetime. There are generally three classes of beneficiaries: Primary Beneficiaries: A primary beneficiary is your first choice of who you want to receive the IRA value at your death. Secondary Beneficiaries: A secondary beneficiary receives the IRA value if your primary beneficiary does not survive you. Final Beneficiaries: A final beneficiary receives the IRA value if none of your primary or secondary beneficiaries survive you. If you do not have a named beneficiary who survives you, your estate becomes the beneficiary, which may produce less advantageous tax and distribution outcomes. If you're married, you can name your spouse as your IRA beneficiary. Alternatively, you can name multiple beneficiaries. If, for example, you have three children, you could name them as the three primary beneficiaries, specifying the percentage of the IRA each will receive. Or, you could name your spouse as the primary beneficiary and your children as the secondary beneficiaries. Keep in mind that a spouse who is the sole beneficiary of an IRA has the option of treating the Inherited IRA as his/her own, meaning that the assets in the Inherited IRA need not be distributed prior to the surviving spouse attaining age 70-1/2. Stretch IRA Review Page 5 of 11
If you have several IRAs, you can name different beneficiaries for each IRA. If you have both a traditional IRA and a Roth IRA, however, keep in mind the different income tax treatment of these two types of IRAs: the beneficiary of a traditional IRA will have to pay income tax on IRA distributions, while the beneficiary of a Roth IRA will receive distributions income tax free. Caution: Certain situations require special care in designating IRA beneficiaries. These include marriages in which one or both spouses have children from a prior marriage, as well as a child or grandchild with a disability or a drug or alcohol problem that might impair their judgment or use of funds from the IRA. In this situation, naming a trust as beneficiary can establish some control over how the funds are used after your death. In addition, see pages 9-10 for a discussion of the bankruptcy protection available to Inherited IRAs. What Happens at a Traditional IRA Owner s Death? Here's where "stretch" IRA planning can come into play. Required minimum distributions from a traditional IRA cannot be avoided during your lifetime. As illustrated by our earlier example, however, required minimum distributions do not necessarily deplete the value of a traditional IRA. Instead, the value remaining can be substantial at an IRA owner's death, when careful advance planning can serve to stretch the tax deferral into the future. The options available to an individual who inherits a traditional IRA include the following: Immediate Lump-Sum Distribution Surrender the Inherited IRA and receive the entire value in a lump sum. The taxable value of the IRA is then included in the beneficiary's income in the year of surrender. Distributions Over Five Years If the IRA owner was under age 70-1/2 at death, the beneficiary can take any amounts from the Inherited IRA, so long as all of the funds are distributed by December 31 of the year containing the fifth anniversary of the original IRA owner's death. This option is not available if the IRA owner was over age 70-1/2 at death. Stretch IRA Review Page 6 of 11
Life Expectancy The IRA assets are transferred to an Inherited IRA in the beneficiary s name, where the date by which required minimum distributions must begin depends on whether or not the beneficiary is the surviving spouse and by the IRA owner s age at the time of death. For spouse beneficiaries: If the deceased spouse was younger than age 70-1/2 at the time of death, the surviving spouse may delay required minimum distributions until the year in which the deceased spouse would have reached age 70-1/2. If the deceased spouse was older than age 70-1/2 at the time of death, the surviving spouse must begin taking required minimum distributions by December 31 of the year following the spouse s death. For non-spouse beneficiaries: Required minimum distributions from the Inherited IRA can be spread over the non-spouse beneficiary's life expectancy, with the first payment required to begin no later than December 31 of the year following the year of the IRA owner's death. The life expectancy option can be used to provide a current stream of income, while still extending the tax deferral of funds in the Inherited IRA by stretching the required minimum distributions over the beneficiary's life expectancy potentially a long period of time in the case of a younger beneficiary. Spouse IRA beneficiaries, however, have an additional option to consider: Spousal Transfer Under this option available only to surviving spouses who are the sole IRA beneficiary, the spouse beneficiary treats the Inherited IRA as his/her own and the IRA assets continue to grow taxdeferred. IRA distribution rules are then based on the spouse s age, meaning that distributions may not be available prior to the spouse s age 59-1/2 without paying a penalty tax and required minimum distributions must begin by the spouse s age 70-1/2. With a spousal transfer, a surviving spouse who does not need current income can continue the tax-deferred growth of the entire Inherited IRA until he/she reaches age 70-1/2. NOTE: Since Roth IRAs have no required beginning date and no required minimum distributions, a Roth IRA owner is not required to take distributions from a Roth IRA during his/her lifetime. At the Roth IRA owner s death, a spouse beneficiary can treat the Roth IRA as his/her own and continue to defer distributions indefinitely into the future. Alternatively, a spouse or non-spouse Roth IRA beneficiary can transfer the assets to an Inherited IRA and elect the life expectancy method, which does have minimum distribution requirements: Stretch IRA Review Page 7 of 11
For non-spouse beneficiaries, required minimum distributions based on the beneficiary s life expectancy must begin no later than December 31 of the year following the year of the deceased Roth IRA owner s death. For a spouse who is the sole IRA beneficiary, required minimum distributions may be postponed until the year in which the deceased Roth IRA owner would have reached age 70-1/2. Let's look at several hypothetical examples using a traditional IRA Stretch IRA in Action: Spouse as Beneficiary of Traditional IRA During Traditional IRA Owner's Life: Owner Dies at Age 74: Surviving Spouse Dies at Age 78: Spouse named as beneficiary distributions must begin no later than age 70-1/2 Surviving spouse, age 65, inherits the IRA, which she treats as her own, naming her three children as equal beneficiaries distributions must begin no later than her age 70-1/2 The three children, ages 45, 48 and 50, inherit the IRA distributions based on the life expectancy of the 50-year-old child begin to all three children OR Surviving spouse, age 65, inherits the IRA, which she splits into three separate IRAs, naming each of her three children as beneficiary of an IRA distributions must begin no later than her age 70-1/2 The three children, ages 45, 48 and 50, separately inherit an IRA distributions are made from each Inherited IRA to each child beneficiary, based on that child s life expectancy NOTE: It is important that IRA beneficiaries name their own beneficiaries. In our example, what would happen if the 48-year-old beneficiary died in 10 years, with value remaining in his IRA? Unless he had named a beneficiary or beneficiaries, such as his spouse or children, the remaining IRA proceeds would be paid to his estate, with potentially less favorable taxation and distribution results. Stretch IRA Review Page 8 of 11
Stretch IRA in Action: Non-Spouse as Beneficiary of Traditional IRA During Traditional IRA Owner's Life: Owner Dies at Age 65: Beneficiary Dies at Age 60: Adult child named as beneficiary (NOTE: In community property states, a spouse may have rights to an IRA, whether or not he/she is named as primary beneficiary) distributions must begin no later than IRA owner's age 70-1/2 Adult child, age 35, inherits the IRA, transfers the assets to an Inherited IRA and names her spouse as primary beneficiary with her children as secondary beneficiaries distributions based on her life expectancy must begin no later than December 31 of the year following the year of the IRA owner s death The beneficiary's spouse inherits the IRA, transfers the assets to an Inherited IRA and names the couple s children as beneficiaries distributions continue, based on the beneficiary's spouse s life expectancy IMPORTANT NOTE: As the spouse and non-spouse examples illustrate, if "stretching out" an IRA is the objective, it is important that the IRA trust or custodial documents used contain language that permits the following: Distributions paid to beneficiaries over their life expectancies; Division of an IRA into multiple separate IRAs; and The naming of successor beneficiaries. IRAs and Bankruptcy Protection The funds in an employer-sponsored retirement plan are protected from the reach of creditors in the event of a bankruptcy. Whether IRA assets enjoyed this same protection had been questionable. With passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, however, effective October 17, 2005, up to $1 million of traditional and Roth IRA assets in the aggregate became protected from bankruptcy creditors. A question remained, however, of whether funds in an Inherited IRA are protected in the event of the beneficiary's bankruptcy. A 2014 Supreme Court decision (Clark v. Rameker) answered that question, ruling that funds in an Inherited IRA are not protected in the event of the beneficiary's bankruptcy. While the spouse of a deceased owner has the option to roll an Inherited IRA into his/her own IRA and retain bankruptcy protection, the rollover option is not available to non-spouse beneficiaries of IRA proceeds. Depending on the type and terms, however, trusts can be used to shield assets, including an IRA, against creditors. Stretch IRA Review Page 9 of 11
If the objective is to create a wealth transfer strategy using the value of inherited IRA assets to benefit future generations, it is important to seek professional tax and legal advice before implementing a plan. Doing so may help avoid unforeseen and/or negative tax and bankruptcy protection consequences. Stretch IRA Advantages and Disadvantages If you will have no need to take money from your IRA above and beyond the required minimum distributions, evaluate these advantages and disadvantages in deciding if a "stretch" IRA is right for you. Advantages The possibility of providing income to one or more generations. The ability to continue the tax-deferred growth of IRA assets during the period of time that distributions are being made. The opportunity to minimize income tax liability by spreading it out over a period of years instead of paying it all at once. Disadvantages The potential expense involved in structuring and administering a "stretch" IRA. Future tax laws and/or regulations may make IRA growth and/or taxation less advantageous to the beneficiaries. Inflation and/or poor investment returns may erode the value of future IRA distributions. An IRA beneficiary may elect to "take the money and run," opting for a lump-sum distribution at an IRA owner's death. It is strongly recommended that you obtain professional tax and legal guidance in structuring a "stretch" IRA in order to fully evaluate: The fees and expenses associated with a "stretch" IRA and its underlying investments. Any tax limitations or withdrawal restrictions in the investment(s) used to fund the IRA. How to protect inherited IRA assets from creditors in the event of bankruptcy. The possibility that future changes in tax laws and/or IRS rules may impact required IRA distributions and/or IRA taxation. The impact of inflation, which will erode the future purchasing power of an IRA. The inability to accurately project future investment results over a long period of time, as well as the market risk inherent in exposing IRA assets to a lengthy distribution period. The impact of a "stretch" IRA on your overall estate plan, including the inability to predict when IRA beneficiaries will die. Stretch IRA Review Page 10 of 11
Important Information The information, general principles and conclusions presented in this report are subject to local, state and federal laws and regulations, court cases and any revisions of same. While every care has been taken in the preparation of this report, VSA, L.P. is not engaged in providing legal, accounting, financial or other professional services. This report should not be used as a substitute for the professional advice of an attorney, accountant, or other qualified professional. U.S. Treasury Circular 230 may require us to advise you that "any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor." VSA, LP All rights reserved (VSA 1a2-19 ed. 01-15) Stretch IRA Review Page 11 of 11