Time for Another Look at Your IRA?

By Thomas Cornellier



Does your independent retirement account (IRA) have the correct beneficiaries? It's important to know that the Pension Protection Act of 2006 brought changes to the administration of IRAs - and many IRA owners have failed to adjust their IRAs to benefit from the new rules.

One of the most crucial changes an investor can make is not to his or her portfolio, but rather to the primary and contingent beneficiaries. If the beneficiary section is not completed correctly, thousands of dollars, if not millions, can be lost to taxes.

Of course, proper asset allocation in your portfolio is critical. But if the beneficiaries are not correct, the gain from even the most successful portfolio can be mitigated by the IRS.

A common error IRA owners make is that they don't make corrections to their beneficiary designations for life-changing events or new changes in tax laws. Without proper action, the IRA owner could lose a large chunk of money to Uncle Sam or worse, disinherit a family member altogether.



Stretching Out

Beneficiaries of all financial products and estate documents should be reviewed annually to make sure they are current, and IRAs are no exception. So how do you save thousands, if not millions, by simply changing the beneficiaries of your IRA?

The answer is: with a Stretch IRA.

The Pension Protection Act allows for non-spouse beneficiaries to roll an inherited IRA into their own IRA and take distributions based on their age and life expectancy. For example, a 2-year-old grandchild can inherit his or her deceased 72-year-old grandparent's IRA and take withdrawals based on the life expectancy of a current 5-year-old.

By stretching out the IRA over the life expectancy of a 5-year-old, rather than that of a 72-year-old, withdrawal amounts decrease significantly, which decreases taxes owed and allows more money to remain in the account for investment and growth.

Bypassing the spouse is not necessary for this strategy to work. If the IRA is needed to provide income to your spouse, by all means, have your spouse as the primary beneficiary. But this is where the contingent beneficiary comes into play. Make certain that the contingent beneficiary section is completed as well, in the event of simultaneous deaths of the owner and primary beneficiary.

If an IRA owner and primary beneficiary die simultaneously, and no contingent beneficiary is named, the IRA goes through a probate process for the court to decide on dispersal of the money. Depending on state laws, a beneficiary will be named, and that beneficiary will inherit the IRA in a lump sum and have to pay income tax on it at his or her current rates.

Also, the more money that must pass through probate, the longer the process takes and the higher the court fees run, draining the estate and assets even more. A sizable lump-sum distribution could push the beneficiary into the highest tax bracket, sacrificing up to 35% of the account balance, not to mention the money lost by not having those dollars invested.

So not naming a contingent beneficiary can be an extremely costly mistake.



Investor Beware

Also, be aware of federal and estate tax exemptions. Currently, your spouse can inherit all assets without incurring an estate tax. However, if your spouse dies, there is a federal exemption of $2 million and an additional state exemption of $1 million in Maryland, for instance.

If the estate's value is more than the exemption, and an IRA is transferred after the death of the second spouse without proper estate planning, a large chunk of the IRA can, again, be lost to taxes. If your spouse is the primary beneficiary of your IRA, and your total estate surpasses these exemptions, contact your financial adviser and estate planning lawyer to plan properly. (There are many simple solutions. For instance, an A-B Trust works well in many cases.)

What if there are co-primary beneficiaries? If the co-beneficiaries are of similar age, the question is most likely moot. But what if there is a significant difference in age between, say, a spouse and a young child? Then you should split the IRA into two different accounts, with the spouse being the beneficiary of one IRA and the child being the beneficiary of the other.

If the IRA owner does not split his or her IRA and leaves co-beneficiaries with significant age differences, then the stretch of the inherited IRA is based on the life expectancy of the oldest beneficiary - in this case, the spouse. The child could lose years of stretching.

A similar case can be made for charities. If a charity is co-beneficiary, your other beneficiaries could lose the stretch option, because the charity is not an individual and therefore has no life expectancy. So, again, it is much better to split the IRA.

If the IRA owner passes away without splitting the IRA, the beneficiaries have until Dec. 31 of the year of the IRA owner's death to make the split. However, this is best done pre-death by the IRA owner.



Protect Yourself

Lastly, what if the spouse or children are spendthrifts or ne'er do wells, and the IRA owner doesn't trust them to make the stretch?

If the IRA owner wants to make sure his or her IRA is protected from a beneficiary taking the money to Vegas and blowing it all on the blackjack tables, a trust can be drafted.

Otherwise, preserve your retirement and add significant dollars to the wealth of your beneficiaries with the Stretch IRA. It's as simple as correctly listing the beneficiaries on your IRA, but it could add to a beneficiary's wealth over his or her lifetime.



Thomas Cornellier is a certified financial planner with Wooden-Cornellier Group in Ellicott City. He can be contacted at 443-325-7775 and thomas@w-cgroup.com.