Extend the life of your children’s inherited IRAs

Extend the life of your children’s inherited IRAs

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A proposal in President Obama’s 2015 budget, if approved, would require nonspousal IRA beneficiaries such as children to accelerate distribution and taxation of inherited IRAs.

All IRA account owners and beneficiaries are required to take annual minimum distributions, or RMDs, using end-of-the-year account values and an Internal Revenue Service life- expectancy table factor to calculate distribution amounts. This enables anyone who owns or inherits a traditional IRA account to defer and stretch out the distribution and associated taxation over their lifetime.

Nonspouse beneficiary: Current and proposed law

Under current law, individual beneficiaries other than a spouse must begin taking annual RMDs by the last day of the year following the year of the account owner’s death, whether or not the decedent was required to begin taking distributions. The distribution period to be used is generally based on the beneficiary’s life expectancy. If the owner died after RMDs began, his or her remaining life expectancy at death can be used if longer. Similar to a spouse, a nonspouse IRA beneficiary may continue to defer distribution and taxation of the original owner’s IRA account for the remainder of his or her lifetime.

If enacted, the 2015 budget proposal would require nonspouse beneficiaries of retirement plans and IRAs to take full distributions of inherited accounts by the end of the fifth year following the account owner’s death. The proposal is effective for distributions with respect to plan participants or IRA owners who die after December 31, 2014.

Reduced planning options

Although there are some proposed exceptions, nonspouse beneficiaries would no longer have the ability to stretch the distribution of inherited IRA’s over their lifetime. While this would accelerate the receipt of federal income tax revenue as well as state income tax revenue to the extent that individual states conform to this change, it would reduce IRA account owners’ and beneficiaries’ planning options.

From the perspective of an original IRA account owner with sizable IRA account holdings whose children are beneficiaries, accelerated distribution following the owner’s death may not be desirable. Trusteed IRAs may currently be used to control how and when IRA assets are left to children. Passage of the IRA nonspousal beneficiary budget proposal would limit the distribution period to five years following the original IRA owner’s death.

Time-sensitive investment opportunity

There’s a time-sensitive investment opportunity available for individuals who own sizable IRA accounts with nonspouse beneficiaries who want to control the timing and amount of distributions of their accounts after they die and are concerned about the passage of the nonspousal beneficiary IRA provision of the 2015 budget.

The investment may be especially appealing to individuals who are worried about the potential erosion of the value of their IRA accounts given the recent all-time stock market highs, and who prefer the safety of sustainable income for themselves and their beneficiaries should they die prematurely. Acknowledging its popularity, the budget proposal permits use of the investment vehicle.

Specifically, the 2015 budget proposal, if approved, would not apply to IRA account owners whose benefits are determined under a binding annuity contract in effect on the date of enactment. Consequently, an immediate or deferred fixed income annuity could be used to potentially extend the lifetime of an IRA where a nonspouse is the beneficiary.

A natural investment choice

Fixed income annuities within IRAs are a natural investment choice for a portion of sizable IRAs where children are primary beneficiaries and there’s a concern about squandering of funds following the death of the original owner. Flexible payout options are available with immediate and deferred fixed income annuities where the start date, term, frequency, and amount of each payment can be chosen by the applicant at the time of investment. In short, the annuity can be customized to control the timing and amount of income that may eventually be received by children.

Fixed income annuities are deemed to comply with the RMD rules provided that payments (a) begin by April 1 of the year following the year that the owner turns 70 1/2 and (b) are structured so that they will be completely distributed over the life expectancies of the owner and the owner’s beneficiary.

Unlike recently-approved qualified longevity annuity contracts, or QLACs, from which lifetime distributions must begin no later than age 85 with a limit of the lesser of $125,000 or 25% of one’s retirement plan balance, there’s no cap on the amount of IRA money that can be invested in fixed income annuities. Furthermore, unlike QLACs, which are currently limited to deferred-income annuities, or DIAs, other types of fixed income annuities can be used.

Limitations on stretching fixed-income annuities

While there are several types of fixed-income annuities that can be used to stretch the lifetime of IRAs upon death of the original owner, there are some that aren’t designed for this purpose. One type, an immediate annuity with a straight life payout option, will never achieve this objective. With a straight life annuity, payments continue to be made for as long as the annuitant is alive. Once the annuitant dies, payments end. Although this option will provide the largest payment, it’s rarely a good choice given the possibility that the annuitant may die after a limited number of distributions have been received.

Another type, term certain income annuities, may or may not result in income being received by a beneficiary depending upon the length of the term and how long the original owner/annuitant lives. There are two types of fixed-income annuities where a predefined number of years or months are used to determine the duration of annuity payments:

  • 1. Immediate annuity with a life and period certain payout option
  • 2. Deferred-income annuity with a defined term

With both types, no payments will be made to any beneficiaries following the owner’s death assuming that he or she survives the predefined term, e.g., 10 years, 20 years, etc. In addition, assuming that payments begin by April 1 of the year following the year that the owner turns 70 1/2, too short of a term is likely to result in 100% of all payments being received during his or her lifetime unless he or she dies prematurely.

Should you take action now?

If you own a sizable IRA account with one or more nonspouse beneficiaries and you want to control the timing and distribution amounts of your account after you die, should you purchase fixed- income annuities for your IRA before 2015?

First and foremost, it should be kept in mind that the 2015 budget nonspousal IRA beneficiary proposal, like many income tax proposals, either won’t be approved or the effective date may be deferred for one or more years. Given the fact that there are only three months remaining in the year, passage by December 31st is questionable.

Having said this, as previously stated, fixed-income annuities within IRA’s are a natural investment choice for a portion of sizable IRAs where children are primary beneficiaries and there’s a concern about squandering of funds following death of the original owner. Also, as previously mentioned, it may behoove you to act sooner than later if the recent stock market highs are making you anxious and you prefer sustainable income for yourself and your children should you die prematurely.

If you’re in either one or both of these situations, I would recommend that you discuss your concerns with a retirement income planner who specializes in working with fixed-income annuities. He or she will be able to recommend specific types of fixed-income annuities and products to you and will customize them to meet your needs. If the nonspouse beneficiary IRA provision of the 2015 budget is made effective on December 31st, you will need to submit your annuity application within the next month or so to increase your likelihood of having a binding contract issued by the date of enactment.

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