Passing an IRA across generations
NEW YORK — Individual retirement accounts - long a favored vehicle for savings and investing - have become a more useful tool for passing along wealth to heirs, thanks to an important change in US tax laws.
Barring any new interpretation by the Internal Revenue Service, beneficiaries of an IRA can avoid taxes and extend the life of this retirement tool.
Until now, beneficiaries of IRAs could not pass them down again. That, in effect, shortened the lifespan of the IRA as an investment product.
Individuals setting up an IRA have always been able to designate a beneficiary for their account. But that meant the IRA usually only shifted between two generations at most, such as a parent and an adult child. Now, the IRA can move beyond the second generation - to a third generation - and possibly a fourth, or fifth, or more. It can also be passed along to people within the same generation (for example, husband to wife, wife to sister, sister to brother-in-law, etc.).
Here's how the change came about: Late last year, the IRS decided that a son who had just inherited an IRA from his mother could establish his own beneficiary. That had not been permissible before the ruling.
Many financial houses are now interpreting that decision as opening the door to legal multiple beneficiaries over time, says Debra Levine, assistant vice president of retirement plans at Pioneer Investment Management in Boston.
Pioneer, for example, has incorporated special language into its IRA forms allowing a beneficiary to name his or her own beneficiary - thus stretching out the life of an IRA over several generations.
Not only does a "stretch IRA" allow a person to move assets into the future, but it also provides a form of up-front tax relief for the IRA holder. The reason: Let's say an elderly woman selects a young person as her beneficiary. The combined age between young and old will provide some fancy math calculations that will minimize the distributions that must be taken when the woman turns 70-1/2. It also means that she has more money available for future compounding.
Subsequent beneficiaries, however, are limited to the number of years in which the first beneficiary could have drawn down the assets in the IRA account, says Ed Slott, an authority on IRAs based in Rockville Centre, N.Y. Thus, "stretch IRAs are not forever," he says.
Whether using IRAs to transfer wealth is the most expedient way of passing along wealth to family members, however, remains open to debate.
The life-insurance industry, for example, which offers annuity products, argues that investors are severely penalized through taxes by transferring wealth through traditional IRAs.
Despite the new IRS ruling, a person can take a tax hit for becoming the beneficiary of an IRA, unlike a life-insurance product, where proceeds usually pass tax-free to the beneficiary.
Tax planners at American Skandia, a Shelton, Conn.-based distributor of insurance products, argue that up to 75 percent of one's assets can be lost to taxes by going the IRA route.
The beauty of an insurance product is that if carefully structured, "it can escape not only federal income taxes, but also estate taxes," says Patricia Abram, senior vice president and national sales manager at American Skandia. By contrast, she says, traditional IRAs can find themselves clobbered by both types of taxes.
Still, IRA holders can reduce the tax hit by switching to a Roth. Interest earnings on Roth IRAs are not taxed if held five years or longer, which could mean substantially larger earnings than through more-conservative life-insurance products.
Whatever the case, the debate between IRA enthusiasts and insurance folks is hardly moot: Millions of individuals have jumped aboard the IRA bandwagon. In 1999, some 34.7 million households held IRA accounts, up from 30.6 million in 1998, according to the Washington-based Investment Company Institute, a trade group.
If you decide to go the stretch-IRA route, says Ms. Levine, be sure you establish the IRA with a provider who has included language to that effect within the IRA document. Experts also agree individuals should check with an attorney or knowledgeable tax accountant before passing IRA assets along to heirs.
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