Whenever I talk about IRAs and estate planning, I can almost see the numbness come over my audience. I can understand why confronting your own mortality comes well behind the name of the latest contestant to be kicked off Dancing with the Stars on the interest scale.
But one aspect of IRAs is genuinely exciting, because it permits you to take a humdrum, modest IRA and turn it into a huge windfall for your heirs. It’s very easy to achieve this goal. Just leave an IRA to a beneficiary of your choice.
Check out this example of the magical power of an inherited IRA, taken from my book, The Smartest Retirement Book You’ll Ever Read:
Assume a forty-five-year-old man inherits a $50,000 IRA from his mother. She took care to educate him about the benefits of an inherited IRA. She cautioned him not to cash it out, because of the immediate tax consequences. He consults with his tax advisers and complies with the rules governing required distributions for an inherited IRA from a non-spouse. (You can find a good summary of these distribution rules here.)
He stretches his required withdrawals out over the next 38.8 years (his life expectancy, according to the IRS). Assuming the funds remaining in the IRA grow at 8 percent per year, he would pull out a staggering $303,113 before the IRA was exhausted.
It’s even better for spouses who inherit an IRA. They have the option to do a spousal rollover. If they elect that option, the IRA will be treated as their own, with the normal IRA rules applying to their minimum required distributions. Basically, these rules don’t require any distributions until the owner reaches 70½ years of age.
Just think about the value of an inherited IRA to a newborn grandchild, who can spread required distributions out over 82.4 years, which is the longest period of time permitted by the IRS.
To ensure your IRA is inherited according to your wishes, you need to take some very simple steps:
1. Check the beneficiary form you filled out when you opened your IRA. Be sure the beneficiary is still the person you want to inherit it. If not, update the form. The financial institution where you opened your IRA will have a copy of the form. Request it, review it, change it if necessary, and keep a copy with your important estate-planning documents.
2. Educate your beneficiary. A little-known minefield can trip up non-spouse beneficiaries. He or she must leave the original owner’s name on the account. If the account is changed to reflect only the beneficiary’s name, the IRS will treat the entire value of the IRA as immediate income to the beneficiary. The IRA must continue to have the decedent’s name on it, and his or her date of death, together with the Social Security number of the beneficiary.
Because of the complexity of these rules, if you have the good fortune to inherit an IRA, you would be wise to consult with a qualified tax adviser. Saving on professional fees can be very costly if you mess up and trigger adverse tax consequences.
Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read and The Smartest 401(k) Book You’ll Ever Read. His latest book is The Smartest Retirement Book You’ll Ever Read.
