Choose IRA Beneficiaries Carefully

I occasionally field an inquiry from someone looking for a “Stretch IRA.” They might have heard about one from a friend or at a seminar. As it turns out, there is no such thing as a Stretch IRA. The term is invented and is meant to describe an advantageous way of maximizing the value of the IRAs we already have.
 
If somebody wants to sell you a Stretch IRA, hold onto your wallet and get out of there. You can easily make your current IRA benefits stretch out over time by simply filling out some paperwork with your IRA custodian.
 
The tax code requires that all IRA owners begin to take required minimum distributions from their IRAs in the year after they turn 70 ½. You determine your own required distribution by dividing your IRA balance by a number that the IRS publishes in a table. A 75 year old man would divide his year-end IRA balance by 23 to determine how much to withdraw. He must make this withdrawal even if he does not need the money.
 
To stretch an IRA simply means to find a way to withdraw the money over a longer period. The key advantage to doing so is that the power of tax-exempt compounding will work for you and your heirs for a longer period.
 
There are two steps to making this happen. The first step is to name beneficiaries who will inherit the IRA and who are younger than you. Children and grandchildren are the usual choices.
 
The second step, while not an attractive choice, is quite necessary. You have to die. That final step complete, you can now stretch your IRA. From the beyond, so to speak. If you happen to die at, say, age 90, you would have withdrawn 18 percent of your account balance that year. If you have named your 34-year-old grandson as the IRA beneficiary, his annual withdrawals drop to 2 percent of the account after he becomes the owner. At this low withdrawal rate, the IRA’s life can be stretched out almost indefinitely.
 
That is all there is to stretching an IRA. Make sure you have designated primary and contingent beneficiaries that are younger than you. Most couples designate each other as the primary beneficiary of an IRA. This makes sense, since the main financial worry of most couples is that the surviving spouse never runs out of money.
 
If the surviving spouse is the primary beneficiary, there is limited ability to stretch the IRA. This is because most couples are close in age. However, the IRS will allow the surviving spouse to disclaim the IRA. The IRA can then pass immediately to the contingent beneficiaries, who are often the couple’s children. The children can then stretch the IRA over their expected lifetimes. A surviving spouse would choose this option if he or she felt they would not need the IRA money. The disclaimer must be made by the September 30 of the year following the year of the original owner’s death.
 
You must name the primary and contingent beneficiaries on the forms provided by your IRA custodian. You should never leave your IRA to someone by saying so in your will or trust documents, and by leaving the beneficiary forms blank.
 
Far too many people have named a living trust, or their estate, as the primary or contingent beneficiary, figuring that the trust documents will direct the IRA to the chosen heirs. The problem with this is that the IRA will be liquidated and closed, and the money taxed, before it goes into the trust. The heirs will receive only a fraction of the IRA balance after income and estate taxes, and have no opportunity to stretch out the payments. There are almost no circumstances where it makes sense to name a trust as the beneficiary of an IRA.
 
Also, note that you cannot stretch a typical 401(k) plan. That is why I always advise people to roll a 401(k) over to an IRA as soon as they leave an employer.
 
If you filled out your IRA paperwork years ago, you might not be sure who the listed beneficiaries are. Call the IRA custodian and check, and fill out new forms if needed.