Investor's Business Daily, April 20th, 2007
Some people build more than enough assets. Even in retirement, they don't need to tap their IRA for living expenses.
Such people can hold off taking money from traditional IRAs until they must take minimum required distributions (MRDs). They must begin by April 1 of the year after the year they reach age 701/2.
Required distributions are set by IRS tables. Any shortfall is subject to a 50% penalty.
Roth IRAs are different. If you're the original owner of one, you never have to make withdrawals, though your heirs do.
So with either a Roth or a traditional IRA, you might be able to leave a sizable amount to one or more beneficiaries. If you plan well, those heirs may be able to enjoy big tax advantages.
You must name beneficiaries carefully. "No matter what your will says, IRAs pass to beneficiaries you have named," notes CPA Ed Slott, who publishes Ed Slott's IRA Advisor, a newsletter.
A so-called cascading beneficiary plan can save the most on taxes. Here's how such a plan can work.
Let's assume that a hypothetical Jack Williams leaves his job, where he had a 401(k) account. He rolls that over to an IRA.
Williams names his wife, Jill, as the primary beneficiary of his IRA. He can also name their children as secondary beneficiaries. This will give Jill flexibility in deciding who gets the assets.
When Jack dies, Jill can claim the inherited IRA as her own. She can then name their children as the beneficiaries of this inherited IRA.
What if Jill feels that she won't need the IRA? She can disclaim the inheritance, and the children will get the account.
While alive, Jack also can name their grandchildren as tertiary beneficiaries. If Jill and the children disclaim, the IRA will pass to the grandchildren.
The process can extend to any generation and nonfamily members, so long as there's a specific person Jack can name. A trust can be among the listed beneficiaries too, and the trustee can disclaim.
Strategic Steps
Why are these steps necessary? "Someone who disclaims an inheritance can't direct where those assets will go," Slott said.
Instead, a person disclaiming steps out of the line. The assets pass to the next one on the list.
By specifying beneficiaries in descending order, you as the original account owner can influence where the money goes.
Disclaimers must be made within nine months of the original account owner's death.
Your surviving family members can look at current tax law and individual finances to decide which of them gets the money from an inherited IRA.
What are some of the potential advantages?
Estate tax savings. Say Jack Williams dies with a $1 million IRA but few other assets. His widow, Jill, is also elderly and in poor health. But she has a large estate of her own, not counting her husband's IRA. She built up wealth in her younger days as a real estate agent.
If Jill accepts the inherited IRA, she may be adding $1 million to her taxable estate. That could lead to hundreds of thousands of dollars in extra estate tax.
Jill's disclaimer keeps the assets in Jack's estate. His estate is small enough to escape tax at his death, thanks to the estate tax exclusion.
There also may be estate tax advantages if the children disclaim in favor of Jack's grandchildren.
Income tax deferral. Minimum distribution rules apply to inherited IRAs. With a traditional IRA, taking only the smallest payout required yearly can prolong tax deferral.
With an inherited Roth IRA, minimum distributions also let earnings keep growing tax-free.
If an older beneficiary disclaims in favor of a younger one, the younger heir can stretch required distributions over a longer life expectancy.
A 58-year-old beneficiary would have to empty an inherited IRA within 27 years. But his 20-year-old daughter could stretch required distributions over 63 years. So her distributions can each be smaller. The MRDs must begin the year after the year of the original owner's death.
That lets more of her money stay inside the account. There, it can grow without earnings being taxed until withdrawal.
To make such plans work, all beneficiaries must be specifically identified on IRA beneficiary forms. You can't list "grandchildren" or "great-grandchildren" as a group.
But some beneficiary forms don't have enough space to list everyone.
"If you don't have enough space, you should not name anyone on the form," Slott said. Instead, write something like, "See separate sheet of beneficiaries attached."
On that sheet, list all primary and contingent beneficiaries.
When there are multiple beneficiaries, use fractions or percentages to specify how the inheritance will be shared. Or write "equally." If you use fractions or percentages, make sure they add up to 1, or 100%.
Whenever you move IRA money to a new financial institution, go over the process again. Always ask for an acknowledgment letter from the IRA custodian, saying that your beneficiary form has been received and its provisions will be followed.
