By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
What is your retirement plan -- 401(k), 403(b), IRA, Roth IRA, etc. -- worth? To you, the answer is as simple as looking at your latest account statement. But to your heirs, your retirement plan could be worth far, far more. The reason is that after your death, the tax law does not force your heirs to liquidate (or cash-out) your account. Rather, it allows them to "stretch-out" your account. That is to say, your heirs are allowed to liquidate your account piecemeal over time, in progressively increasing portions (see chart below). This allows your heirs to put that potent duo -- time and tax-deferred compounding -- to work for them.
The value of a stretch-out
Use the table below to estimate the "stretch-out" value of your retirement plan. First, find the age closest to the age of your heir. Next, pick a rate of return that you think your retirement plan will earn after your death. Finally, multiply the value of your retirement plan (or, if you are older than age 70 ½, the value of your retirement plan less your required minimum distribution [RMD] for this year, if not yet taken) by the number found in the box where age and rate of return meet. The product is the stretch-out value of your retirement plan, or, the total of all of the RMDs that would be paid to your heir should you die this year and should your heir choose to stretch-out (and not cash-out) your account.
Let's take two examples. First, assume that Frank, age 77, has a $500,000 traditional IRA. He has not yet taken his $24,000 RMD for this year. Frank named his son, Steven, age 45, as the sole beneficiary of the IRA. If Frank dies this year, if his IRA earns 6 percent per year going forward, and if Steven stretches-out, Steven will receive $1,972,544 ($500,000 - $24,000 = $476,000 x 4.144) in total RMDs over his (IRS-assumed) 37-year life expectancy. Though these distributions will be subject to income tax at Steven's rates, the tax is only due when an RMD is paid. Moreover, even though Steven is under age 59 ½, the 10 percent penalty will not apply to any of his RMDs.
Next, assume Gertrude, age 85, owns a $750,000 Roth IRA that she plans to leave to her granddaughter, Amy, age 25. Gertrude would like to know the cumulative total of payments that would be made to Amy over Amy's 57-year (IRS-assumed) life expectancy, assuming a 7 percent rate of return, and assuming that Amy stretches-out. The stretch-out value of Gertrude's account is $10,770,000 ($750,000 x 14.360). Gertrude did not have to reduce the $750,000 by her RMD for the year because Roth IRA owners are not subject to the RMD rules, only Roth IRA beneficiaries are. In addition, because RMDs from Roth IRAs are totally tax-free, Amy will pay neither an income tax nor the 10 percent penalty tax on any of the $10,770,000 distributed!
The role of trusts
The stretch-out opportunity is, however, somewhat illusory because its success depends upon a number of things "going right." First and foremost, if a retirement plan is left to an heir outright, he or she must continually resist the temptation to cash-out. This is easier said than done for most heirs. Second, the heir must avoid all the misfortunes that can bring creditors into the picture. These include liability from operating automobiles or watercraft, from professional malpractice, from serving as an officer or director of a business, from home ownership, from business ownership, from personal guarantees, from divorce, etc. This is critical because case law in this area over the past decade (summarized on the chart below) has clearly demonstrated that there is virtually no creditor protection for inherited IRAs left outright to heirs.
Trusts can help on both fronts. First, a properly designed "stretch-out" trust can eliminate the cash-out temptation by eliminating the cash-out option. Instead, the trustee is directed to take only the RMD from the account. And, should the primary beneficiary die before the account is depleted, future RMDs would be paid to those chosen by the IRA owner -- not the primary beneficiary. This means that the benefit of the stretch-out will stay within the IRA owner's bloodline.
Second, a properly designed stretch-out trust is a legal person separate and apart from its beneficiary. Thus, the trust owns the account, not the beneficiary. Since a creditor can take only what a beneficiary owns, a creditor of a stretch-out trust beneficiary can, at best, take RMDs when paid from the trust. The following chart summarizes the advantages of a bequest of a retirement plan to a stretch-out trust versus an outright bequest.
What to do next
A retirement plan can be a windfall inheritance because of the ability to stretch-out. Though a trust is not strictly needed for a stretch-out to occur, experience has shown that heirs (particularly younger ones) rarely, if ever, stretch-out. And even should an heir have enough self-discipline to stretch-out, an outright bequest still allows a retirement plan to pass outside the bloodline or to creditors.
If you are serious about your heirs' enjoying the maximum benefit possible from your retirement plan, be sure to establish and name stretch-out trusts as beneficiaries of your retirement plans. Your heirs will be glad that you did.
The author would like to acknowledge the significant contributions made by his partner, Salvatore J. LaMendola, in the preparation of this article.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.
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