Keep It Together

Parlay Your IRA into a Family Fortune: 3 Easy Steps for creating a lifetime supply of tax-deferred, even tax-free, wealth for you and your family
by Ed Slott

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Dear Ed,
I am age 73, have several IRAs, am currently taking minimum distribution, and have my beneficiaries listed to receive equal shares, which I do not think is the right thing to do. Or is it? The ages of my beneficiaries are 78, 51, 49, and 42. I need some guidance as to what would be the right way to go.

— IRA owner

The Ninth Wonder of the World

The Devil Is in the Details

Bill and his two siblings had inherited a $270,000 IRA from their mother, a widow when she died in 2002. Their mom had bequeathed to them equal shares of her account. Bill informed the financial institution holding the account that he and his brother and sister wanted the proceeds split three ways so that each could manage his or her own share of the inherited IRA. This is normal, since most adult beneficiaries (Bill and his siblings were in their 30s) usually don't want the others knowing how they are investing or spending their share of the inheritance.

The advisor at the financial institution then cut three checks, one for each sibling, for $90,000 apiece. Simple as pie! Right?

Wrong!

Early in 2003, Bill went to have his 2002 taxes prepared and was told by his accountant that he owed tax on his $90,000 inheritance - $30,000 in tax, as a matter of fact!

Bill went into shock.

When he saw me quoted in a recent Wall Street Journal article on inheriting IRAs, he called me out of desperation, even though we didn't know each other from Adam. He related his woeful tale and asked if his accountant was right. Did he really owe $30,000 in tax? I told him yes.

"But it's worse than that," I added. He owed not only $30,000 in tax on the $90,000 inheritance, but also state tax on it, plus tax on all his regular income (wages, interest, etc.). The $90,000 he'd taken had pushed him into a higher tax bracket, which resulted in all of his income being taxed at a higher rate than it otherwise would have been. Furthermore, due to his increased income, he lost out on many tax benefits that he would have qualified for, such as the child tax credit, medical deductions, and work-related tax deductions. Bill's siblings were in the same boat.

Through weak links along the entire chain - their mom's not having set the IRA up correctly, their lack of awareness as beneficiaries as to how to inherit the account properly, and the professional ignorance of the financial advisor in managing the transition of the IRA - most of what their mom had worked for was wiped out instead of having a chance to blossom.

Now Bill was experiencing awe and shock. He asked, "Is there anything that can be done to correct this?"

"No," was my answer.

"Couldn't I get the financial institution to put the money back in Mom's IRA and start over the right way?"

Again my answer was no. Our tax laws do not allow that. Our tax laws are rigid, unforgiving, and draconian in this area. Once a mistake is made, it is often irreversible. In Bill's case, all the money was removed; therefore all of it was taxable in the year it was moved, and it could not be returned. The opportunity to parlay the inheritance into a fortune was lost to Bill and his siblings for all time. Game. Set. Match.2 Astounding Growth Through Long-Term Compounding

With the blessing of the IRS (but don't expect any government press releases coming out and saying so anytime soon), a scenario can be created where the value of any inherited IRA can grow into a fortune. The reason most people don't create this scenario for themselves and their families is simple: They don't know about it.

Why not? The answer to that is simple too: The tax rules are so abstruse that many financial advisors and the institutions they represent who deal with retirement accounts don't know about it either - or shrink from offering any kind of tax advice.

If I were passing on an IRA to someone, I would want to know that I could choose that the money I had worked so long and hard for would go intact to my family, who could then parlay it into a fortune, instead of its being lost to taxes that might otherwise be avoided.

One would assume that most estate planners (as well as books on estate planning) address this issue. But they don't. Yes, they cover how to inherit a house, stocks, insurance, and so on, because these are easy to inherit. These types of assets are not loaded with their own set of obscure tax rules.

For example, there is no law that says that when you inherit a house, the first year you can take possession of the kitchen, the second year you can take possession of the bathroom, then the third year you can take possession of the roof, then the den, and so on. Then every time you take possession of one of these items, you must pay income tax and become subject to an entire set of separate tax rules that, if not followed correctly, could lead to stiff fines rather than growth and income. If the IRA rules applied to other property like your house, for example, then after your death Uncle Sam could end up moving in, since he would already own most of the home anyway. Maybe your kids could rent the basement.

Inherited IRAs are subject to such complex tax rules. And while those rules can work against you if you do things wrong, they can also work to your benefit if you do things right - and make your family rich! And the best part is, you don't have to start out with an IRA worth a fortune in order to achieve that goal. How so? Through the magic of the Ninth Wonder of the World - the phenomenon I call "compound interest on steroids," otherwise known as the "stretch IRA." Here's how it works.

If your beneficiary inherits a $100,000 IRA from you, the value of that IRA depends on how long it stays in the hands of your beneficiary and is protected from taxation. If it is taxed immediately after your death, the IRA will have little value to your beneficiary. But if your IRA is set up properly and your beneficiary handles this inherited IRA properly, it can be worth a fortune over his or her lifetime.

The tax rules allow any person you designate as your IRA beneficiary to stretch (extend the required distributions) that IRA over his or her lifetime. The term "designated beneficiary" for tax purposes means that you have named a person (as opposed to an estate, a trust, or a charity, for example) as heir to your IRA. This is like bestowing royalty upon someone, because an inherited IRA can only be stretched over the lifetime of your designated beneficiary, whom you name as such on an IRA beneficiary form (see Chapter Five).

© 2005 Viking, a division of Penguin Putnam, used by permission.

About the Author

Ed Slott is a highly sought-after professional speaker, CPA, and tax adviser. His diverse client list includes major corporations such as Fidelity Investments, American Express, Merrill Lynch, Nationwide Insurance, and Oppenheimer Funds. Ed Slott frequently appears in The Wall Street Journal, The New York Times, USA Today, and on broadcast television and radio programs nationwide. He is publisher of the popular monthly newsletter "Ed Slott's IRA Advisor." For more information about Ed Slott and his numerous speaking engagements, please visit his website: www.irahelp.com.