COLUMN-'Stretch' IRA tax shelter on the chopping block

Tue Feb 14, 2012 11:56am EST

By Mark Miller

Feb 14 (Reuters) - Inherited retirement accounts are truly one of those gifts that keep on giving because heirs can benefit for many years without much tax burden, but Congress is starting to talk about curtailing breaks on the accounts.

A revenue-raising proposal floated in the Senate Finance Committee last week would sharply limit the time allowed for the liquidation of inherited Individual Retirement Accounts (IRAs) and 401(k)s. Currently, heirs can choose between taking a lump sum distribution, or stretching out distributions over many years. Heirs who do take the longer-range distributions from these so-called "stretch IRAs" can, in turn, pass on the accounts to their own beneficiaries, allowing the assets to yield tax-sheltered returns for decades.

The Senate proposal would place a five-year limit on retirement account liquidations. The change would help finance a major transportation funding bill, raising $4.6 billion over 10 years by accelerating income tax due on assets coming out of retirement accounts. And it would grandfather in existing inherited accounts.

But it appears to be going nowhere fast right now.

The idea is worth considering, however, because it could surface in future tax reform debates. The debate starts with a valid point about tax policy: The idea behind preferential tax treatment for IRAs and 401(k)s is to help people save for their own retirement, not to make long-term tax-advantaged gifts to heirs.

Currently, the inheritor of a traditional or Roth IRA must at least take a Required Minimum Distribution (RMD) each year as defined by the Internal Revenue Service, starting the year after the original owner's death. Beneficiaries younger than 59 ½ can take distributions without incurring the usual 10 percent federal early withdrawal tax penalty.

401(k) plan sponsors also can offer beneficiaries this choice, although many only offer lump-sum distributions. In those situations, an heir desiring long-term withdrawals would simply roll the account over to a traditional or Roth IRA outside the workplace plan.

In the case of a spousal heir, the inherited assets can be rolled over into an IRA in his or her own name, which allows the heir to delay RMDs until age 70½. Or, a widow can maintain the account as an inherited IRA, in which case RMDs would need to begin in the year following the death of the spouse - again, without being subject to early withdrawal penalties. (In situations where a younger spouse dies, the inheritor might want to choose an inherited IRA, because the rules permit her to delay taking RMDs until the date when the deceased spouse would have been 70½).

For many heirs, a lump sum may sound attractive. But keep in mind that retirement account distributions are taxed as ordinary income upon withdrawal. The exception to this rule is an inherited Roth IRA, which is funded with after-tax dollars (inherited Roths are subject to the RMD rules).

A lump sum can generate a sizable one-time tax bill that has unintended consequences, such as pushing the heir into a higher tax bracket. For older heirs, a lump sum could also affect the percent of Social Security income subject to taxation in a given year, or trigger costly high-income Medicare premium surcharges.

"A Roth really is the ideal vehicle for an inherited IRA," says Christine Fahlund, senior financial planner at T. Rowe Price. "The heir can stretch out the asset for decades based on her life expectancy, and all the assets come out tax free - the initial contribution and the returns on investment." (Fahlund offers a caveat here: while Roth assets are free of income tax, they are included as an asset for estate tax purposes.)

RMDs are based on an IRS formula driven by the heir's life expectancy; the RMD is calculated by dividing the account total by the number of years the heir is expected to live. That means RMDs are much smaller when the heir is young - but the obligation must be managed carefully. Failure to comply results in a 50 percent tax on whatever the RMD should have been for a given year. (The life expectancy tables used to calculate RMDs can be found in IRS Publication 590 ().

Stretch IRAs can generate impressive long-term returns, because they continue to grow tax free. And, since most of the funds won't be withdrawn for years, the assets can be invested for aggressive returns.

T. Rowe Price offers this example, assuming a 7 percent annual pre-tax return:

A man dies at age 70, passing on a $100,000 traditional IRA to his 45-year-old daughter, who maintains it as an inherited IRA and takes her first RMD in 2013. When she passes away at age 75, her son inherits the IRA at age 49, beginning his own RMDs in 2043, and depleting the account fully in 2049. The daughter would have enjoyed lifetime withdrawals of $256,951; passing on $163,583 to the son. He, in turn, would benefit from lifetime RMD withdrawals of $178,047.

Fahlund finds that clients with smaller account balances are comforted to learn that even a modest gift to an heir can generate that kind of long-range benefit.

"Many of our clients like the idea of passing along an IRA to adult children who may not have saved enough for their own retirement, or to help them pay college expenses for their kids," she says.

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