Maximizing the Value of Inherited IRAs
Stretching an inherited IRA is extremely valuable to the beneficiary. Learn what that means.
An inherited IRA, or “beneficiary IRA”, is an account that gets opened when someone inherits an IRA after the death of its owner. The beneficiary may open an inherited IRA from any variety of eligible IRAs, from Roth and rollover to Simple IRAs and SEPs. This IRA beneficiary is subject to required minimum distributions (RMD) in which all the benefits needs to be distributed within five years. With a stretch inherited IRA, the beneficiary is instead eligible to stretch the RMDs out over their own life expectancy instead of that of the deceased. Given the power of compounding interest, that can make a huge difference.
Illustrating the Power of Time and Yield
We created a chart and a few scenarios to illustrate what a significant difference this can make in maximizing the value of the inherited IRA. The critical factors are annual yield and the age of the beneficiary; that is why well-advised clients often leave their retirement plans to grandchildren rather than to children.
Sally, age 20, is named as the beneficiary of Grandpa’s $100,000 IRA account, which she receives shortly after his death. Sally is self-disciplined and gets excellent advice, so she manages to stretch the RMDs over her lifetime, allowing the undistributed principal to grow tax free. If her average annual yield is 6%, by age 85 she will receive just over $1,000,000 from the account – a 10x return. But if her annual yield is 10%, she will receive over $6,000,000 – a 60x return!
Age of Beneficiary
Grandpa instead leaves his $100,000 IRA account to Sally’s 50-year old mother Betty. Betty is equally self-disciplined, so she also stretches the IRA distributions over her lifetime. If her yield is 6%, then she will receive over $325,000 from the account – a 3x return. Remember, however, that 20-year-old Sally would have received a 10x return, simply because of the age difference between the two beneficiaries. The importance of age is even more striking if the yield is higher. If the yield is 10%, Betty will receive a return of just less than 8x over her lifetime, compared to Sally, who would receive a 60x return.
* Assumes beneficiary’s lifetime of 85 years or more, and that withdrawals are limited to RMDs. Data gathered by using the calculator at www.hughcalc.org/mrd.cgi (c) 2018 CunninghamLegal
It is easy to calculate cumulative values of inherited IRAs with initial values other than $100,000, simply by adjusting figures on the table proportionally.
- If Sally, age 20, inherits a $200,000 IRA with a 6% yield, the estimated cumulative value of the Stretch IRA would be just over $2,000,000, twice the amount shown on the table, because the value of the IRA at the date of death was 2 x $100,000. (Note that the 3x return on the investment remains the same.)
- RMDs are added to the beneficiary’s taxable income each year, except for RMDs from inherited Roth IRAs, which are not taxed.
People fail to understand the high value of stretch IRAs to family members. As a result, some account owners purposefully draw down their IRAs even though they don’t need to, mistakenly believing them to be of less value after death than other assets they can leave to their loved ones. Other account owners leave retirement plans to charities rather than to family, or leave retirement plans to older beneficiaries because they don’t understand the greater value to younger beneficiaries.
There are a variety of reasons that most beneficiaries do not benefit from the full value of their inherited IRAs:
- The designated beneficiary is the owner’s estate, or no one at all…thus implicitly leaving it to their estate. No stretch-out
- The designated beneficiary is the owner’s living trust. No stretch-out. (Although the applicable laws and regulations might appear to allow a stretch-out in this situation–assuming the living trust is written perfectly for that purpose–the IRS has not approved this strategy and has actively opposed it in individual cases.)
- The beneficiary is not financially disciplined enough to save his inheritance for the future.
- The beneficiary does not understand the value of the stretch-out, so she/he does not attempt to benefit from it
- The beneficiary invests in ways that result in low yields
- The inherited IRA is lost to the beneficiary’s divorce, creditors, or bankruptcy
Do Your Planning
The IRA Legacy Trust ensures that beneficiaries avoid the problems noted above. But the stretch out in these trusts is not an automatic process, and it takes a sophisticated estate planner to understand the rules and properly implement it. We are happy to share our expertise with you to maximize the value of your IRA for generations to come.
Source: Edward W. Goodson, Attorney at Law.
200 Auburn Folsom Rd., Suite 106, Auburn, CA 95603