IRAs are popular investment vehicles for retirement. But if you don’t need all the assets in your IRA to support yourself after you retire, they can also be an excellent tool for estate planning.
Handled properly, an IRA can provide tax-sheltered growth for your heirs for many years to come. But you need to be careful, because it can be easy to make costly mistakes.
An IRA, or Individual Retirement Account, is a personal savings plan that allows you to set aside money for retirement. The advantage of an IRA is that you may be able to deduct some or all of your contributions from your taxes. Earnings in an IRA generally aren’t taxed until they’re distributed to you, at which point you pay income tax on the distributions. However, the assets in the IRA will have had a chance to grow through investment during this time without any capital gains or other taxes.
(This is true of a traditional IRA. There are also “Roth IRAs.” With a Roth IRA, you don’t get a tax deduction for your contributions, but you don’t have to pay tax when the money is distributed.)
Once you reach age 70½, you must start taking distributions from a traditional IRA. You must take out at least a minimum amount each year, which varies depending on your age and life expectancy.
But if you don’t need all the money in your IRA to live on, you can take only the minimum amount, and leave the rest of the assets in the account to grow and eventually pass along to your heirs.
Here are three things to consider:
Name beneficiaries. Give some careful thought to the beneficiaries of your IRA. A spouse may be a logical choice for a beneficiary, but if you name your spouse, be sure that you name contingent beneficiaries as well. If you don’t do so, then if you and your spouse die at the same time, or if your spouse dies and you’re not able to name a new beneficiary afterward, then the IRA will go to your estate.
It’s usually not a good idea to have your IRA go to your estate. For one thing, your estate will be subject to probate, which can result in costs and delays. Probate assets are also made public, so anyone can learn the details of your financial matters, which you might prefer to avoid. Further, having the IRA go to your estate can destroy a number of potential tax advantages.
You should know that if your spouse inherits an IRA, he or she can roll it over into his or her own IRA. When someone other than a spouse inherits an IRA, that person will need to start taking minimum distributions within a year after the IRA owner dies.
‘Stretch’ your IRA. If you don’t need all the funds in your IRA for retirement, you might want to “stretch out” your IRA. To do this, when you reach 70½, take only the required minimum distributions, leaving more assets in your IRA. When you die, your beneficiary can also take only the minimum distributions and “stretch” these distributions out over his or her lifetime, giving the IRA assets many extra years in which to grow tax-deferred.
It makes sense to name a young beneficiary, because the younger the beneficiary, the smaller each annual distribution must be, so there will be more assets in the IRA that can accumulate through tax-deferred growth.
If your heir doesn’t need all the funds in the IRA to live on, he or she can also name a second-generation beneficiary, and the tax savings can accumulate over many more years.
Name a trust as the beneficiary. In some cases, it may make sense to name a trust as your IRA beneficiary. This is particularly true if you have minor children, children with special needs, or a beneficiary who is not good at managing money.
While a trust can be a valuable idea, it’s essential to consult with an attorney to make sure the trust is properly drafted, because a mistake in the way the trust is set up can destroy the tax advantages of an IRA “stretch-out.”