I am being asked more and more in my estate planning practice to assist clients with planning for their 401ks and IRAs. These Qualified Retirement Benefits are more and more prevalent in estates between $1,000,000 and $10,000,000, and encompass a large portion of these individuals wealth. Often, the IRA or 401k is the individual’s largest asset. As such, my success in helping my clients is dependent on my ability to help plan for these assets.
The main buzzword when it comes to estate planning with 401Ks and IRAs is “STRETCH”. Why not!? After all, a properly stretched IRA will end up providing possibly millions over the lifetime of a client’s loved ones. This is because a beneficiary needs only withdraw from the IRA or 401K their required minimum distribution, or RMD. Their “RMD” will depend on their age. The lower the age, the lower the RMD, and the longer the assets will remain compounding in a tax-free environment.
The compounding interest in a tax-free environment produces amazing results. Let’s take a look.
According to calculations provided by http://www.finance.cch.com, which is a wonderful free site I use in part to show clients the effects of a stretched IRA, a $250,000, growing at 10% a year, inherited by a 50 year old child who lives till age 80, will result in over $2,150,000 of distributions over the course of that beneficiaries lifetime. The effects when inherited by a 20 year-old grandchild are even more striking. That grandchild, with the same assumptions, will receive just under $20,000,000 of distributions.
These results are amazing, but not guaranteed. Most IRAs, from anecdotal evidence, are not stretched. This may occur because the beneficiary is improperly advised, a mistake is made, or just plain anxious to spend the money. Take the same IRA as above, but change the projections to the IRA being withdrawn upon receipt. Whether the Beneficiary is 20 or 50, income tax is due on the full amount of the IRA. Assuming at 35% federal and state tax, the $250,000 IRA becomes a $162,500 IRA.
You can guarantee a Stretch with proper planning. Clients should make a “Stretch IRA Trust” the beneficiary of their IRA, or a contingent beneficiary after their spouse. A Stretch IRA Trust provides that each beneficiary shall receive only the Required Minimum Distribution each year. This will force the Stretch to occur and “force” the beneficiary to receive millions of dollars worth of distributions.
An added benefit of the Stretch IRA Trust is asset protection. Thanks to guidance provided PLR 200537044 (obtained by fellow WealthCounsel member Phil Kavesh) the trustee may distribute the RMD directly to the beneficiary, or, if the beneficiary’s distribution will be subject to a creditor, may “accumulate” the distribution within the trust. This added layer of protection makes the Stretch IRA Trust far preferable to an outright designation of a child as a beneficiary of an IRA or 401K.
Financial Advisors, however, must advise their clients about peripheral issues to a Stretch IRA. For instance, the client should have sufficient assets outside the IRA to pay estate taxes due on the IRA. If IRA assets are used to pay an estate tax, they are subject to income tax, and a large portion of the IRA can be lost. As such, a survivorship policy (held in an Irrevocable Life Insurance Trust) is essential to providing liquidity to pay any estate tax obligation, absent adequate cash on hand.
In addition, the advisor should make sure that there are adequate other assets to provide for the beneficiaries in the early years of the Stretch. Because of the nature of RMDs, withdrawals are small at first, and increase every year. Take the example of our 50 year old recipient above. His initial withdrawal at age 51 is only $7,856.79. However, his withdrawals increase over time, and at age 71, he will possibly take a $57,564.71 withdrawal. This delayed gratification may cause the client to adjust their estate plan to allow for the distribution of other assets more liberally in the early years of inheritance, to make up for the small IRA distribution. A life insurance policy may also be appropriate here.
As more and more baby boomers begin planning with large IRA accounts, it is inherent upon advisors to show clients the advantage of a “stretch”, and to set about the mechanism to make sure that stretch happens in the form of a Stretch IRA Trust.
