The stretch IRA: A simple yet powerful estate planning tool

The IRA’s value as a retirement planning tool is well known: IRA assets compound on a tax-deferred (or, in the case of a Roth IRA, tax-free) basis, which can help build a more substantial nest egg. But if you don’t need an IRA to fund your retirement, you can use it as an estate planning tool to benefit your children or other beneficiaries on a tax-advantaged basis by turning it into a “stretch” IRA.

Stretching the benefits

Turning an IRA into a stretch IRA is simply a matter of designating a beneficiary who’s significantly younger than you. This could be, for example, your spouse (if there’s a substantial age difference between the two of you), a child or a grandchild.

If you name your spouse as beneficiary, he or she can elect to roll the funds over into his or her own IRA after you die, enabling the funds to continue growing tax-deferred or tax-free until your spouse chooses to begin withdrawing the funds in retirement or must take required minimum distributions (RMDs) starting after age 70½. (Note that RMDs don’t apply to Roth IRAs while the participant is alive.)

If you name someone other than your spouse as beneficiary, he or she generally will have several options:

  • Take a lump-sum distribution of the IRA’s balance.
  • Withdraw the funds by the end of the year of the fifth anniversary of your death (if you die before beginning to take RMDs).
  • Withdraw the funds over your “remaining” life expectancy, calculated under the applicable IRS table as of the year of death (if you die after beginning to take RMDs).
  • Hold the funds in an “inherited IRA,” which allows the beneficiary to spread RMDs over his or her own life expectancy.

Usually the inherited IRA is the best choice because it maximizes the benefits of tax-deferred or tax-free growth.

Naming a trust as beneficiary

A disadvantage of naming your child or grandchild as beneficiary of your IRA is that there’s nothing to prevent him or her from taking a lump-sum distribution, erasing any potential stretch IRA benefits.

To ensure that this doesn’t happen, you can name a trust as beneficiary. In order for a trust to qualify for stretch treatment, it will need to meet certain requirements, such as distributing RMDs received from the IRA to the trust beneficiaries.  You will need to make sure that your estate planning attorney is well versed in the requirements for naming qualified retirement plans as beneficiaries of trusts–the drafting must be precise in order for the trust to be a qualified beneficiary.

Contact us for additional details.

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Are your retirement savings secure from creditors?

A primary goal of estate planning is asset protection. After all, no matter how well your estate plan is designed, it won’t do much good if you wind up with no wealth to share with your family.

If you have significant assets in employer-sponsored retirement plans or IRAs, it’s important to understand the extent to which those assets are protected against creditors’ claims and, if possible, to take steps to strengthen that protection.

Employer plans

Most qualified plans — such as pension, profit-sharing and 401(k) plans — are protected against creditors’ claims, both in and out of bankruptcy, by the Employee Retirement Income Security Act (ERISA). This protection also extends to 403(b) and 457 plans.

IRA-based employer plans — such as Simplified Employee Pension (SEP) plans and Savings Incentive Match Plans for Employees (SIMPLE) IRAs — are also protected in bankruptcy. But there’s some uncertainty over whether they’re protected outside of bankruptcy.

IRAs

The level of asset protection available for IRAs depends in part on whether the owner is involved in bankruptcy proceedings. In a bankruptcy context, creditor protection is governed by federal law. Under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), both traditional and Roth IRAs are exempt from creditors’ claims up to an inflation-adjusted $1 million.

The IRA limit doesn’t, however, apply to amounts rolled over from a qualified plan or a 403(b) or 457 plan — or to any earnings on those amounts. Suppose, for example, that you have $4 million invested in a 401(k) plan. If you roll it over into an IRA, the entire $4 million, plus all future earnings, will generally continue to be exempt from creditors’ claims in bankruptcy.

To ensure that rollover amounts are fully protected, keep those funds in separate IRAs rather than commingling them with any contributory IRAs you might own. Also, make sure the rollover is fully documented and the word “rollover” is part of its name. Bear in mind, too, that once a distribution is made from the IRA, it’s no longer protected.

Outside bankruptcy, the protection afforded an IRA depends on state law.

What about inherited IRAs?

In 2014, the U.S. Supreme Court held that inherited IRAs do not qualify as retirement accounts under bankruptcy law. The Court reasoned that money in an IRA retirement account was set aside “at some prior date by an entirely different person.” But after an inheritance, it no longer bears the legal characteristics of retirement funds because the heir can withdraw funds at any time without a tax penalty and take other steps not required with non-inherited IRAs. Therefore, they’re not protected in bankruptcy. (Clark v. Rameker)

Consult with your attorney about protection for retirement accounts in a nonbankruptcy context.

Protect yourself

If you’re concerned that your retirement savings are vulnerable to creditors’ claims, please contact us. The effectiveness of these strategies depends on factors such as whether future creditor claims arise in bankruptcy and what state law applies.

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