What is an IRA and how is it taxed?
IRAs (Individual Retirement Accounts) are part of a class of assets know as retirement accounts or
"qualified money." Generally speaking, the comments made in this section are true of all types of
retirement accounts except for Roth IRAs. IRAs consist of dollars you contributed and the interest
earnings on those dollars. You have never paid any tax on any of the money so you must pay tax on
each dollar you withdraw. Additionally, because Congress wanted you to save the money for your
retirement, you must pay a 10% additional tax if you withdraw money before you are 59 ½. Also,
because Congress was afraid you would not withdraw the money when you retired so they could collect
taxes, they require you to start taking a minimum amount of money from your account at the age of
70 ½. These minimum withdrawals are called "required minimum distributions". They are taxable.
You can take more if you want but whatever you take is taxable.
Spousal Rollover One of the three best tax provisions in the Internal Revenue code is called a "Spousal rollover". (The other two are the "Stretch IRA" and "tax free life insurance proceeds".) The spousal rollover provision allows your surviving spouse to inherit your IRA without paying any tax at your time of death. The tax will come due as the money is withdrawn but not at the time of transfer from you to your spouse. This is important because it allows your IRA to grow while your spouse is taking withdrawals.
The Non-Spousal Inherited IRA If someone inherits your IRA who is not a spouse, different tax rules apply. The beneficiary gets three choices. First, they can take the IRA in a lump sum, withdrawing all the money in one year, and reporting it all as income. This means they could pay as much as 40% to the government as income tax. Second, the beneficiary can take the money over 5 years and spread the income over 5 years. This could result in paying less than 40% in income taxes. Thirdly, the beneficiary could select the " Stretch IRA." They could start taking required minimum distributions based upon their age (even though they were not yet 70 ½) and having to pay tax on only the required minimum distribution amount. Selecting this procedure, they could get a check from your IRA every year for the rest of their life.
Problems with the Voluntary Stretch IRA The Stretch IRA is attractive to many parents and children but there are a number of problems in establishing and maintain the Stretch IRA. If you are considering it for your children or grandchildren, consider the following:
• The majority of adult children, given the choice of a lump sum now versus a check each year will pick the lump sum now. Many want it to buy a new car, a big screen tv or to take a trip. They are willing to give up to 40% to the IRS.
• In order to have a Stretch, you must have set up your IRA and your IRA Beneficiary form correctly. One famous elder law attorney estimated that 50% of the owners of an IRA could not find their IRA distribution form and, of those who could, over 90% were wrong or incomplete. Even if you have a revocable living trust named as beneficiary of your IRA, there is a good chance that your children cannot Stretch based upon their ages due to recent changes in the tax law. If you want your children to Stretch your IRA, you need to have your IRA beneficiary designation and your trust reviewed by an elder law attorney who is also understands IRA distribution planning.
• If a child is collecting government benefits such as SSI or Medicaid, the income from the Stretch IRA could eliminate those benefits.
• Even if your children decide to Stretch the IRA, it can be defeated by future events. For example, if your child is Stretching, and dies, the child may leave the IRA to his spouse who then cashes it in or does a spousal rollover and someday names her new husband the beneficiary of your IRA. Or, if your beneficiary is Stretching the IRA but has financial trouble, his creditors can attach the lump sum of your IRA. Or, if your beneficiary is Stretching the IRA but his spouse files for divorce, the IRA could be part of the divorce settlement.
The IRA Inheritance Trust
The IRA Inheritance Trust is a special trust used to Stretch and IRA and protect it from a beneficiary's divorce, creditors, bankruptcy or wild spending habits. It solves all the problems of the voluntary IRA. It allows you to use your IRA to create a legacy. You could use your IRA to provide each of your children, grandchildren, etc. with a check for every year of their life. It can even be set up to arrive on their birthday or at Christmas. A qualified elder law attorney can explain the details of the IRA inheritance trust and help you set one up.
