The stretch IRA, when implemented properly, can be one of the great vehicles for transferring wealth to your heirs, maintaining the tax-deferred status until much later. The problem is that there are some very specific terms that must be met in order to achieve the stretch – and if you screw it up, there’s definitely not a do over in most of these cases.
First, let’s run through the specifics that make up a stretch IRA situation. When an IRA account owner dies, the beneficiary(s) are eligible to re-title the account(s) as inherited IRAs in the name of the deceased owner, and then begin taking Required Minimum Distributions based upon the beneficiary’s age – rather than having to take the entire sum all at once and pay tax on it, or the onerous five-year distribution rule that can come into effect if things aren’t done properly.
Keep in mind that these stretch rules apply to both Traditional and Roth IRAs – even though Roth IRA owners are not subject to RMD, their beneficiaries are.
What we’re here to discuss are the some of the common mistakes that can be made when attempting to stretch an IRA.
- Not properly titling the account – if the account is set up in the name of the non-spouse beneficiary, the funds would be immediately taxable and the IRA would be distributed. There’s no remedy to this one, the account has to be titled as “John Doe IRA (Deceased January 1, 2009) FBO Janie Brown” or something very similar.
- Doing a “rollover” – while it may seem like an issue of semantics, there is a technical difference between a direct trustee-to-trustee transfer and a rollover. The trustee-to-trustee transfer is self-describing; a rollover is when the beneficiary receives a payment made out in his own name, which he then deposits into an IRA. A rollover is disallowed in attempting to set up a stretch IRA – you must always do a direct trustee-to-trustee transfer.
- Neglecting timely transfer – sometimes estates can be tied up for years getting everything sorted out. IRAs and 401(k) plans should not have this sort of problem, as generally there is a specific beneficiary or beneficiaries designated on the account documentation. It is critical that the funds are transferred into a properly titled account before the end of the year following the year of the deceased owner’s death – otherwise the stretch IRA option is lost, and the funds will have to be paid out via the five year rule.
- Failing to take RMD for year of death – if the IRA owner dies after his RBD, a Required Minimum Distribution must be taken for the year of his death, and can not be included in a transfer to an inherited IRA. This one can cause some hiccups, but in general can be resolved if caught in a timely fashion by taking the distribution in the name of the decedent and paying the applicable penalties for excess accumulation. If the amount is transferred to the inherited IRA and isn’t caught quickly, it could negate the stretch altogether, causing big tax bills.
- Missing or neglecting RMD payments – if the beneficiary forgets to take the Required Minimum Distribution payment in a timely fashion, technically the five-year rule could kick in, requiring that the entire balance is paid out within five years, rather than the beneficiary’s lifetime. However, it is possible to recover from this mistake, according to the outcome of a Private Letter Ruling (PLR 200811028, 3/14/2008). What happened in this case was that the beneficiary neglected to take two years’ worth of RMD, and then corrected her mistake in the third year, taking all three years’ worth of RMD, followed by paying the penalty (50%) on the missed two years. The IRS ruled that the failure to make these distributions in a timely fashion does not require that the five year rule apply – and since she maintained the appropriate distributions, caught up on the “misses” and paid the penalties, she is allowed to continue stretching the IRA over her lifetime. Interestingly, this particular PLR is the first place where the stretch IRA was determined as the default rather than the five-year rule, breaking ground for this to be the case across the board, unless the plan’s provisions require the five-year rule.
- Not properly designating the beneficiary(s) – IRS regulations state that the beneficiary must be identifiable in order to be eligible for the stretch provision. This means naming an individual or individuals as specific beneficiaries on the account forms, or designating a proper “see through” trust (with specific beneficiaries named) as the beneficiary. The account form can not have something ambiguous like “as stated in will” – since this does not name an identifiable beneficiary. In addition, if the original IRA beneficiary is a trust and any beneficiary of the trust is not a person, then the stretch IRA provision is lost for all beneficiaries.
- Transferring the balance to a trust – if a qualified “see-through” trust is the beneficiary of the IRA, the balance of the funds in the IRA are NOT transferred to the trust – but rather the IRA is transferred directly to a properly-titled inherited IRA, and then RMDs are taken from the IRA and paid to the trust. According to the trust’s provisions, the payments are then made to the trust beneficiary(s). If the payments are simply passed through the trust to the trust beneficiary(s), then each beneficiary will be responsible for any tax on the distribution. If the funds are accumulated in the trust, they are taxable to the trust (to the extent that they exceed $10,700 in income).
Obviously this isn’t an exhaustive list, but rather a sampling of some of the more common sorts of errors that folks make when attempting to set up a stretch IRA. Done properly, this sort of arrangement can turn an IRA of a sizeable amount in your lifetime into a very significant legacy to your heirs. Proper setup is very important – get a professional to help you with it if you are confused by how this works!