The Stretch IRA is a powerful wealth transfer strategy, because it “stretches out” your IRA’s ability to grow tax-free.
The basics of establishing the Stretch IRA are as follows:
- Name younger beneficiaries
- Be sure your beneficiary designations are up to date
- Discuss the Stretch IRA with your beneficiaries
After that, it’s time to consider the next steps to maximize the after-tax value of your IRAs for the next generation.
Here’s how you do it…
You want to consider having a custom beneficiary designation form (BDF) or naming a trust as the beneficiary (or both). The standard BDFs of most IRA custodians limit the options available to you and your beneficiaries.
You should know, of course, that the BDF controls who inherits your IRAs.
Your will or living trust matter only if you name your estate or the trust as the beneficiary, and by doing that you lose some valuable tax-deferral potential.
Moreover, when a trust is named IRA beneficiary, the power of a Stretch IRA is available only if the trust has special provisions required by IRS regulations that qualify it as a “look-through” trust.
Let’s take a look at some of the key planning issues, how standard forms can hamper you, and how a custom BDF or trust can be superior. (Some people even go as far as to suggest that a custom BDF is a “second will.”)
Let’s say you want each of your children to inherit a share of your IRA… only, not equal shares.
Perhaps one child is financially better off than the others. Or one or two of the children received more gifts over the years, or will receive a larger share of other assets in the estate.
Another scenario might include giving one beneficiary a specific dollar amount, while the others share the rest of the IRA. This might be done when you’re leaving part of the IRA to charity and the rest to your children, as one example.
Whatever your situation, always remember the default for most IRA custodians is that multiple beneficiaries of an IRA receive equal shares. And some beneficiary forms make it difficult or impossible to state clearly that beneficiaries will inherit unequal shares.
To be certain of the result you want, it’s a good idea to have your estate planner draft a custom BDF that spells out how much of the IRA each beneficiary inherits.
Suppose “Max Profits” has three adult children, and names them as equal beneficiaries of his IRA.
One of the children, Hi, passes away. Max passes before he updates the BDF.
The law provides two possible results:
If the beneficiary designation is “per stirpes,” then Hi’s estate or heirs will inherit his share.
If the beneficiary designation is “per capita,” then the other beneficiaries will inherit Hi’s share, and Hi’s heirs will be cut out.
If you don’t designate which result you want, the IRA custodian’s default provision is in control. In fact, almost all IRA custodians provide that per capita designation is the default.
Bottome line: If you want a different result, you need a custom BDF that says so.
Also, under the per capita designation, the remaining beneficiaries can inherit the deceased beneficiary’s share either equally or pro rata (based on their current shares of the IRA).
This only matters if these beneficiaries aren’t receiving equal shares, but is very important in that case. Some custodians provide the remaining beneficiaries inherit the deceased beneficiary’s shares equally while others provide for pro rata inheritance.
Again, you can change the result with a custom BDF.
The Successor Beneficiary
Many people want and expect their IRAs to last for more than one generation. But who inherits after your initial beneficiary?
Most standard BDFs don’t allow for the designation of a successor beneficiary. They have a place to designate a contingent beneficiary who will inherit if the primary beneficiary doesn’t survive to inherit the IRA or disclaims the inheritance. But the custodians often don’t provide for designation of a successor beneficiary.
In fact, most of the major IRA custodians don’t allow you to name a successor beneficiary.
If there’s a balance in the IRA after the original beneficiary passes away, the custodian’s default provision controls who is successor beneficiary.
Most IRA custodians say the estate of the deceased beneficiary is the successor beneficiary. Others provide the surviving spouse of the beneficiary, if any, is the successor beneficiary, and then either the estate or children of the deceased beneficiary.
You also should be aware that if you designate a successor beneficiary, the original beneficiary might be able to change your plans by moving the inherited IRA to a new custodian.
Also, some custodians allow the original beneficiary to change the successor beneficiary once the IRA is inherited.
So, what can we make of all this?
When you want to determine who inherits the remainder of your IRA after the original beneficiary, have your estate planner determine the custodian’s policies.
If the custodian provides for designation of successor beneficiaries, be sure to designate one. You might need a custom BDF to make your choice clear.
When a successor beneficiary isn’t allowed by the custodian (or you’re concerned the designation might be changed after you pass away), consider designating a trust as the primary beneficiary of your IRA.
Your estate planner will need to draft a trust agreement that satisfies the IRS regulations to maintain tax deferral.
[Next week in Part 2, we’ll go over additional strategies for your Stretch IRA.]
Until next week,
Editor, Retirement Watch Weekly