Is Your IRA in the right bucket?

The weather is getting warmer, it’s raining, and the birds are singing in the mornings.  So you know what that means…

It’s time for spring cleaning!

As we clean out the garage and do yearly upkeep on our homes, we shouldn’t neglect our estate plans.  Proper maintenance is the key to the success of your living trust.  And just like your furnace has different needs than your air conditioner — so too does your retirement account have different needs than your checking account.

Retirement accounts — IRA, 401(k), and other employer-sponsored plans — aren’t just a great way to save for your retirement.  They’re also a great way to use the power of compound interest and tax-deferred growth (or tax-free growth for a Roth account) to turn thousands into millions.

I often compare a living trust to a bucket for holding money and assets.  But take a wrong turn — by using the wrong kind of bucket — and your heirs will stand by helplessly while the IRA custodian completely pays out the IRA and closes the account.

What would your heirs end up with?  No compound interest.  No tax-deferred growth.  And a giant tax bill from Uncle Sam.

This problem is actually more common than you might think.  But before we dig into how your IRA might be broken, let’s take a look at how it’s supposed to work.

Stretch Your IRA Distributions

The IRS allows an inherited IRA account to be distributed over the life of the beneficiary.  This is called “stretch out” of distributions, or a Stretch IRA.  So if you pass away leaving your IRA to your 35 year old son, the IRS uses his life expectancy to calculate minimum distributions — not yours!

Some living trusts aren’t designed to work with retirement accounts and don’t support stretch out of any kind.  These trusts force an IRA into the Five Year Rule.  That means the IRA must be completely paid out by the end of the fifth year after the owner’s death.

But some institutions don’t even give you that long.  You may be forced to take a single distribution, paying all the taxes in a single year (say hello to the 35% tax bracket if you inherited a sizable IRA). This happened to a recent client of mine.  Her father’s IRA was distributed in one large payment because the living trust didn’t meet the IRS stretch out rules.

It makes sense that the later you pay taxes, the better off you will be. Let’s take a look at an example to see just how much better is a stretch IRA than falling under the Five Year Rule.

See the Stretch in Action

Imagine you leave a $100,000 IRA to Angela, your 30-year-old daughter or granddaughter.  Angela has a professional job, putting her squarely in the 28% income tax bracket.

Angela invests the IRA in growth mutual funds.  It’s tough to predict what the stock market will do (just look at the past two years for evidence of that).  But we will assume that, over the long term, the IRA earns a 5% annual return, adjusted for inflation.  History suggests that Angela might be able to achieve a 7% return, but let’s be conservative.

The IRA With a Lump Sum Distribution

Let’s assume that Angela received her inherited IRA from a living trust just like the one my client’s father had.  Angela receives $72,000 from the original $100,000 IRA after taxes.  If Angela invests that money and never spends a cent, she could expect to have $239,643 when she retires at 65 (under the above assumptions).

That sounds pretty good.  And keep in mind that we adjusted for inflation.  If we hadn’t, the final figure would have been much higher. So the $240k figure is in today’s money, shopping at today’s prices.

The Stretch IRA is going to have to be pretty good to beat that.  Let’s see how it does…

The IRA with Stretch Out Distributions

If Angela is able to stretch out her distributions, she won’t have to pay any taxes up front.  She will have to take small distributions each year that are required by the IRS (called Required Minimum Distributions, or RMDs).  Over the next 35 years, those distributions will add up to $190,698 after taxes.

But even after all the distributions, Angela would still have $138,423 remaining in her trust (after taxes, if she took it as a lump sum payment at age 65).

The total value of Angela’s IRA over the 35 year period is $329,121.

You read that right.  The Stretch IRA beat the lump sum distribution by almost 73%.

The lump sum distribution performed respectably, getting Angela a nearly 240% return on her investment.

But would you turn down an extra 90% profit? I didn’t think so.

Now, of course, this is just an example.  But they show the tremendous growth potential of an IRA when it remains intact and is allowed to grow for decades.

Imagine fully funding the retirement of your grandchildren — before they have even graduated from college.  That’s what a stretch IRA can do for your family.

Securing Your IRA Stretch Out

By now you might be thinking, “Ok, Natalia — just tell me what I should look for on my beneficiary form.”  Unfortunately, it’s not that simple.  Two things will determine whether your IRA can be stretched out or will fall under the Five Year Rule:

  1. How your beneficiary form is filled out
  2. The terms of your revocable living trust

You will probably need the help of an attorney to sort this out — particularly if your living trust is the beneficiary of your retirement account.  One wrong step could cost your children hundreds of thousands of dollars over their lifetime.

If you have a large IRA (over $100k) and are concerned about stretch out, you might consider a Retirement Plan Trust.   It works in many ways like a living trust, but it is specifically designed to meet the IRS stretch out rules for retirement accounts.

Call our office if you would like to discuss stretching out your retirement accounts or want to learn more about the Retirement Plan Trust.

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