An Individual Retirement Account (IRA) can play a role in extending your legacy to future generations if you prepare now.
An IRA is well-known as a powerful tool for retirement planning, but you may not realize that it can also help provide a valuable means of supporting your legacy. An IRA that is passed on to future generations offers considerable long-term benefits, including the chance to maximize the growth potential of an inheritance and potentially lessen the income taxes attributable to the IRA assets by stretching the post-death distributions over the life expectancy of the beneficiaries. Taking steps now to integrate your IRA into your estate plan may enable you to pass along more of your assets to those people and causes you care most about.
Name Your Beneficiaries Well
Using an IRA to help support your legacy starts with deciding who to name as the beneficiaries of your account. A will or trust won't override beneficiary designations on your IRA, so it's important to give these designations careful consideration.
“Before making a designation,” says Kenneth Johnson, Wealth Planning Director at Morgan Stanley, “you should ask yourself some basic questions: Who is going to be receiving these benefits? How will they be taxed? And how long do you want this to last?”
Failing to correctly name beneficiaries could result in the account passing to an heir who is not prepared to manage the account for maximum benefit. For example, naming an elderly parent as IRA beneficiary makes it less likely that he or she will be able to take advantage of the IRA’s potential to provide long-term income; naming a younger person as beneficiary of your IRA—and providing a different asset for your aging parent—may be a strategy that better matches the intentions of each bequest to the individual’s circumstances.
Certain beneficiary designations also can trigger unnecessary estate taxes (including generation skipping transfer taxes) or subject the assets to accelerated income taxes. With the help of your Financial Advisor and tax advisor, you can make sure your beneficiary designations prevent such outcomes while accurately reflecting your final wishes about the distribution of your assets.
"Stretch" Your IRA
A “stretch IRA” strategy is one of the most powerful ways to extend the tax-deferred benefits of an IRA across multiple generations. The IRA stays in the owner's name following death, with beneficiaries required to take minimum distributions annually. But these distributions are generally calculated based on the life expectancy of the beneficiary, rather than that of the former IRA owner.
The value of this strategy is that it generally allows IRA beneficiaries to take smaller distributions, leaving more funds in the account with the potential to grow tax-deferred. The funds are only taxed upon withdrawal and are not subject to a 10% penalty tax on early distributions. Moreover, beneficiaries can increase the dollar amount of their distributions at any time.
It's common to name a spouse as beneficiary, but choosing a child or grandchild could enable the assets in the IRA to be stretched over a longer period. “Typically, if your goal is to stretch the benefits of your IRA, the younger the beneficiary the better,” Johnson says. However, you should discuss with your legal and tax advisors whether naming your grandchild (or certain others) as your beneficiary may have generation skipping transfer tax implications.
Consider a Roth IRA
Roth IRAs may present even greater opportunities to help support your legacy than Traditional IRAs. Stretching a Roth IRA will not only extend the account’s potential for tax-deferred growth, but may also provide beneficiaries with tax-free income. Unlike Traditional IRAs, there are no age restrictions with a Roth IRA. There is no contribution cutoff, provided income requirements are met, and no rule that you must begin tapping your account at age 70½ − so you can leave as much of the money in the account for your heirs as you wish (but after your death, your beneficiaries must take the required death distributions).
Income limits restrict who can open a new Roth IRA or contribute to one, but anyone can convert funds from a Traditional IRA or employer-sponsored retirement plan to a Roth IRA. Taxes will be due on the converted funds at time of conversion, and it’s smart to pay those taxes with funds outside the IRA to keep the account's assets intact for your heirs. Also, if you use your IRA funds to pay the conversion taxes and you are under age 59 ½ at the time, the funds you use to pay the taxes may be subject to a 10% penalty tax, in addition to ordinary income taxes.
Trusts and Charitable Giving
If you intend charitable giving to be part of your legacy, gifting an IRA (rather than other assets) to charity may be an effective strategy to minimize taxes. When Traditional IRA assets are passed on to children or grandchildren, both estate and income taxes may need to be paid on the IRA assets, effectively reducing the total value of the inheritance. Any distribution from an IRA to a tax-exempt charity, on the other hand, generally qualifies for the federal estate tax charitable deduction. In general, the charity can draw funds without paying income tax, and your estate can take a charitable deduction for the amount left to the charity. Your Financial Advisor, along with your tax advisor, can help you explore which assets should be directed to your heirs and which to charity.
Designating a properly structured trust as a beneficiary of an IRA can be another useful strategy for maximizing the potential of the account for future generations. There are many potential advantages to using a trust in this way, including providing for children who are minors or have disabilities, or controlling the cash flow to prevent diminishing the value of your bequest too soon. You should, however, discuss this with your legal and tax advisors before you designate a trust as your IRA beneficiary.
Planning for the Unexpected
Once you develop a strategy for using your IRA to help support your legacy, keep in mind that you will probably need to make adjustments to your beneficiary designations and the IRA’s role in your estate plan over time. Your life circumstances may evolve and your legacy goals may shift. However you choose to integrate your IRA into your estate plan, it's essential to decide how you want the funds directed, and to review this decision regularly. “If you don’t name qualified “Designated Beneficiaries”, dealing with the IRA after your death could be complicated and expensive for your heirs,” Johnson cautions.
Consider discussing with your Financial Advisor:
- Your overall legacy goals
- How your current IRA beneficiary selections coordinate with your estate plan
- Whether your beneficiaries are prepared to manage your bequest responsibly
Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not “fiduciaries” (under the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise provided in a written agreement with Morgan Stanley. Individuals are encouraged to consult their tax and legal advisors regarding any potential tax and related consequences of any investments made under an IRA.