Establishing an Inheritance with Your IRA

| September 4, 2013

inheritance ira sean williamsIf you had the opportunity to make an informed and educated financial decision for the benefit of your future heirs instead of relying on a default policy, would you?

I hope your answer is a resounding “Yes!” As we accumulate wealth our largest financial asset often becomes our Individual Retirement Account (IRA). If you take the necessary steps your IRA may continue to grow tax-deferred for your heirs for decades. A modest sum could grow to be a financial legacy for your heirs.

Unfortunately there is often a lot of misunderstanding when it comes to structuring the account to benefit those that may one day inherit the account. Often the focus is only on the individual investments held and their performance, leaving another key factor for long-term growth overlooked.

Establishing the appropriate beneficiaries can have a large influence on your wealth for years to come. For example, once non-spousal beneficiaries receive an IRA they must take at least the annual Required Minimum Distributions mandated by the IRS. The annual Required Minimum Distributions will be based on the heir’s life expectancy. So, in the case of a Traditional IRA, the portion that is withdrawn will be taxed as income at the beneficiary’s income tax rate. However, the greatest benefit is that the remaining balance will continue to grow tax-deferred until withdrawal, maximizing the tax-deferral.

The heir can keep more money in the IRA for future generations by naming a younger beneficiary. When a younger beneficiary is named, the life expectancy of the original IRA increases so that required minimum distributions decrease in size. This strategy is often called a “Stretch IRA” because the tax-advantages and account stretch from one owner to another. This can have a profound impact on one’s family for decades, potentially even generations, if implemented correctly. You may list your children as beneficiaries and then once inherited your children could list your grandchildren as successor beneficiaries. This strategy may also work for non-relatives.

Unfortunately one of the common mistakes people make when considering legacy planning is not listing the appropriate beneficiaries on their IRA accounts. It is important to know that your will does not control who gets your IRA. An IRA is a contract which may bypass the will. If there is no beneficiary form on file the financial institution will follow its own default custodial policy. The policy will dictate whether the IRA goes to a living spouse, the estate, or living children. If the IRA goes to the estate the tax-advantages will cease and the account will be liquidated as a lump sum and the income tax paid. It is very important to be sure your IRA account has the appropriate beneficiaries listed.

Also, beneficiaries may unwittingly cash out the accounts in lump sum, not realizing the benefits lost by cutting the tax-advantaged benefits short and creating a potentially large tax burden.

An additional and surprising pitfall is that some financial institutions may lack the necessary language or provisions to allow for these stretch IRAs. It is important to know that your specific IRA account lists a primary and contingent beneficiaries. It is also important to recognize that an Inherited Beneficiary IRA is a specifically titled account. A beneficiary who is not a spouse should not rollover the original owner’s IRA into their own personal IRA. Once the IRA becomes an Inherited IRA it is important that the institution allows the beneficiary to name successor beneficiaries. Not allowing successor beneficiaries may shorten the tax-advantaged benefit for subsequent beneficiaries.

As with most things financial, educated planning and informed decisions can have a large impact on one’s wealth. A beneficiary form is a relatively simple thing. The tax code is not. Be sure your finances are orchestrated to perform what it is you seek to accomplish.

 The Stretch IRA feature is designed for investors who will have a surplus above their own retirement needs.Under a stretch strategy distributions from a traditional IRA will generally be subject to income tax at the beneficiary’s tax rate. Qualified distributions from a Roth IRA are tax free. Investors should consider various factors that can affect their decision such as investment risks and tax law changes. Investing involves risk and investors may incur a profit or a loss.

This article is meant to be general in nature, should not be considered as investment or financial advice related to your personal situation. Waddell & Reed does not provide tax or legal advice and this information is not meant as tax or legal advice. You should consult with the appropriate tax or legal professional before making any financial decisions.

Category: Finances

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Email | Website | Sean M. Williams is a Certified Financial Planner™ (CFP®) practitioner with Sojourn Wealth Advisory LLC in Timonium, Maryland. Sean serves families and business owners. You can connect with him at