Many clients have used an individual retirement account to help build a healthy retirement income portfolio. Those clients who own a large IRA but no longer need the funds for retirement will be looking to reduce taxes and increase the amount of wealth they can pass on to their heirs. A Stretch IRA is a tool that can increase wealth for beneficiaries over several generations.
What is a stretch IRA?
Clients may have a traditional IRA that is funded on a pre-tax basis and taxed when distributions are made. Or they may have a Roth IRA funded on an after-tax basis and not taxed when distributions are made.
Either can be used to create a Stretch IRA for one or more designated beneficiaries. The "stretch" in the IRA anticipates that when the client passes away, the beneficiaries will take distributions from their inherited IRA over their individual life expectancies, s-t-r-e-t-c-h-i-n-g out the value of the distributions to their heirs.
Is a stretch IRA right for your clients?
There are primarily two Stretch IRA designs: (1) a simple stretch; and (2) a generational stretch. When your client passes away, either IRA will be subject to income tax and (potentially) estate tax. If a client wants to protect the full value of the IRA for heirs, he or she can add the protected stretch to their planning. The protected stretch uses life insurance proceeds to pay the income and estate taxes on either IRA, enhancing long-term benefits for your client's heirs.
The simple stretch IRA can be established when the client attaches one or more beneficiary designations on the IRA. The children would typically be primary beneficiaries; grandchildren or others would be contingent beneficiaries. When the client passes away, the designated beneficiaries will inherit the IRA.
What your clients should know about a simple stretch IRA
Although the client anticipates that the designated beneficiaries will stretch an inherited IRA over their individual life expectancies, there are no restrictions on distributions from a simple stretch IRA. If the designated beneficiaries prefer not to spread distributions over their life expectancies, they can liquidate the inherited IRA after they receive it. If they do so, they will pay income tax and may also pay estate tax on the liquidation of a traditional IRA. Liquidation of a Roth IRA will be tax-free when properly structured.
The generational stretch IRA can be established prior to the client's death by naming a conduit trust as the beneficiary of the IRA for the benefit of the client's primary and contingent designated beneficiaries. Under the terms of the conduit trust, a subtrust is established and named for each child or grandchild.
An IRA beneficiary designation form should be completed and filed with the pertinent information on each child's subtrust. Copies should be given to the client's financial and legal advisors. Upon the death of the client, distributions from the trust will be made to each separate subtrust and paid to the beneficiary in accordance with the terms of the trust.
What you should know about a generational stretch IRA
By establishing the conduit trust, clients can specify that the generational stretch IRA cannot be liquidated by the beneficiaries, and that distributions will be made to them over their individual life expectancies. The unrelated trustee can be given discretion regarding distributions, enabling the trustee to execute the client's wishes over the lifetimes of the beneficiaries. Upon the demise of each primary beneficiary, the remaining assets distribute to separate subtrusts for the next generation. (See chart.)
To illustrate, consider Mary and Mark, a high net worth couple in their late 70s who have a significant retirement income portfolio in two IRAs (one for each). Knowing they have sufficient income to fund their remaining retirement years, they are now comfortable with adding an irrevocable life insurance trust to their estate plan. Mary and Mark are exploring funding options with their financial advisor.
They plan to initially fund their irrevocable trust with a portion of their IRA distributions and leave the balance of their IRAs at their deaths to subtrusts under the ILIT for their primary beneficiaries.
How it works
Mary and Mark's lawyer drafts the ILIT document and the trustee purchases a life insurance policy on each of their lives. When the first of them passes away, the death benefit will be used to pay income tax and possibly estate tax on the deceased's IRA. When the survivor passes away, the death benefit will be available to pay income tax and estate tax on the other IRA. The death benefit, which is estate tax-free and income tax-free under current federal income tax law, keeps the IRA intact for the beneficiaries to receive distributions over their individual lifetimes.
A stretch IRA is a highly effective tool for increasing wealth for your clients' beneficiaries over several generations, particularly when coupled with an irrevocable life insurance trust. Creating subtrusts for their children and grandchildren under the generational trust provides for orderly distributions of the IRA assets. Greater leverage is provided when the trustee purchases life insurance to "protect the stretch." The death benefit is free of income tax and estate tax, creating a more efficient and cost effective way to pay the taxes on their IRA.
Deborah Moon, Esq., CLU, is director, advanced markets for Sun Life Financial, Wellesley Hills, Mass. She can be reached at firstname.lastname@example.org.