For the last several months we have been writing about how the possibility of a Secular Bear Market may be unfolding and if it does it could rob your portfolio of gains, principal or both. From our view it is a distinct probability, what with all the financial/economic tumors that appear to be metastasizing. What compounds those issues is the relatively complete ineffectiveness of our policymakers on both sides of the aisle (not a coincidence that both candidates promise to be the agents of change). Hopefully these missives have shed a light on some of the reasons to be vigilant and strategies to protect your portfolio.
Today we want to discuss how the Internal Revenue Service can be just as devastating to the assets you have accumulated over your lifetime. Most investors are aware that income and estate taxes are the main forces of the IRS in collecting their fair (?) share. What many do not realize is that a poorly constructed IRA account could hand over gobs of assets unnecessarily to the IRS. One mishandled form has cost people hundreds of thousands of dollars.
This regulations revolving around IRA’s and other retirement plans are wide, deep, and can be confusing. Multiple books have been written about the topic. We are going to cover a just one area that is just the tip of the iceberg. The target of this conversation is most aimed at not the owner of IRA’s, but their beneficiaries. Usually the real damage of mishandling the succession of an IRA is realized when the owner has passed. The response by the heirs is usually, “I had no idea that I would owe that much money!”
Many IRA’s we have seen set up have the spouse as the primary beneficiary and if there is more than one contingent, the family trust as the contingent beneficiary. The thought is that the trust will effectively distribute the funds evenly to the kids who are usually the contingent beneficiaries. If the IRA owner and spouse were to pass in a tragedy, the trust would be the beneficiary and the ability to defer taxes over the children’s lives is lost forever. Remember we said this is complicated and there are times where a trust might be the most effective beneficiary.
A Stretch or Multi-generational IRA allows non-spouse beneficiaries to take annual minimum distributions determined by their life expectancy rather than have to distribute the proceeds within the IRS sanction five years from the owners death. This could mean tens of thousands of dollars, maybe hundreds of thousands? Imagine a thirty year old inheriting a $500,000 IRA and keeping it for the five years at 7%. At the end of the five years the account had grown to just over $700k and that would have to be distributed fully and taxed. A $700k distribution would probably put the heir in the highest income tax bracket for that year, making the big winner Uncle Sam. Now if the beneficiary had stretched the IRA to age 83 which is possible, and his account kept growing at 7% annually, she/he could have received over $5.3 million dollars in a more tax effective manner. Keeping the tax advantage of the IRA alive has a significant compounding effect.
Now maybe the non-spouse beneficiary needed those funds immediately after the owners death, then the stretch provision is moot. The point is that they have the option, without planning they have no option. We heard an insightful phrase in our recent reading on the subject, “The IRS has a plan for your IRA succession, don’t you think you should too.
As we said earlier this is just the tip of the iceberg when it comes to succession planning for your IRA. We think it is important to review your current custodial rules and beneficiary designations to determine if you have set up your succession as effectively as possible. We believe it is even more important that if you are a beneficiary of an IRA or other retirement plan to assist the owner in making sure the details of the plan are covered clearly with your financial advisor, tax planner, and custodian. It could be an expensive oversight.
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