Who will inherit more of your estate, the kids or Uncle Sam? The difference is often a Stretch IRA.

By Michael R. Panico, CFP®

We talk a lot about inheritance and estate protection at our workshops. Those planning for retirement often express the desire to transfer as much of their unused nest egg as possible to the people they love most. Unfortunately, many of us are not successful due to being clueless about RMDs as they pertain to succession.

Required Minimum Distributions, more commonly known as RMDs, are withdrawals made compulsory by the IRS once an owner of a qualified account, like an IRA, turns age 70 ½. But what happens when an IRA owner passes away and their spouse inherits the money? Does the spouse need to take RMDs?

The answer is … yes. The surviving spouse must take RMDs based on their own attained age. I would suggest you download a copy of the Uniform Lifetime Table, which will let you know how much of your IRA you need to withdraw every year based on age. But what happens when IRA money is inherited by a non-spouse beneficiary like children? Do the kids need to take RMDs?

The answer is … it depends. Does that matter? Let’s use an example to explore the difference a little planning can make.

I’ve got two kids who I love equally, so let’s assume one day they inherit the million dollars that Dad accumulates in his IRA. That’s $500,000 a piece. Typically, without any planning, that inheritance is taxed immediately as ordinary income. Let’s go a step further and assume the kids are successful professionals earning $100,000 per year when this happens. The following April, the IRS is going to see that they have over $600,000 in ordinary income. Are they going to pay a lot or a little in tax?

They’re going to pay a whole lot! In fact, due to our lack of planning, they’re almost certain to find themselves in the highest tax bracket. And depending on which state they live in, between federal and state taxes, they might see over 40% of their inheritance disappear in the blink of an eye. This is why we tell people that the biggest beneficiary in the United States is often Uncle Sam himself.

So what could have been done differently? In short, the family could have taken steps to set up a Stretch IRA. A Stretch IRA subjects a non-spouse beneficiary to a different RMD schedule called the Single Life Expectancy Table. The IRS is still going to get its taxes, but the bill can now be stretched out over several years. In our example, if my boys come into their IRA inheritance at age 55, they would only be compelled to withdraw about 5% of their inheritance that year. That’s going to suppress their tax bracket, save them a whole bunch of money and give them greater control of the money. Seems like a no-brainer, right?

So why do so few people know about Stretch IRAs? Call me a cynic, but once a person or custodian is already managing your money, there is very little incentive to educate you about important ancillary issues like Stretch IRAs. It’s a shame because setting up a Stretch IRA is easy as long as the correct paperwork is filed in a timely manner. Helping to establish Stretch IRAs is standard practice for our clients.

We tell people over and over that retirement planning is about much more than just juggling around your investment portfolio every year. A complete plan considers all the ancillary issues, including who gets to keep the most of your unused nest egg.

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