Monday, May 9, 2011

Why a “Stretch IRA” Simply Begs the Real Question (PART 1)

Why a “Stretch IRA” Simply Begs the Real Question (PART 1)

Let’s say – hypothetically speaking – that at the time of his death in 2010, George Senior owned a traditional IRA worth $200,000, and his 39-year-old son, George Junior, was the sole beneficiary.

 As is generally the situation with all pre-tax (or qualified) plans such as 401(k)s, 403(b)s, and the like, George Junior must pay income-tax on the entire $200,000. A very important caveat to note here is that I am limiting this discussion to income tax only. I am ignoring federal and state estate taxes, as well as inheritance taxes, because while those may or may not apply, Junior and everyone who inherits any qualified plan must at the very least pay income tax. There’s no way around that.

Generally speaking, all the income tax must be paid within five years of the account owner’s death. So pretty much, George Junior could withdraw the entire $200,000 in one year or spread it out any way he desires, as long as that happens by December 31st of the fifth year – which would be 2015 in this scenario.

Now let’s keep things really simple by holding all other variables constant and assume a combined federal and state tax rate of 25 percent as we consider the various options available to George Junior.

Option 1: If George Junior decided to withdraw the entire $200,000 in 2011, he’d have to send the IRS an income tax check for $50,000 (25 percent of $200,000), giving him $150,000 to keep.

Option 2: On the other hand, let’s say Junior decided to spread the $200,000 out equally over the five-year legal timeline. Each year, he’d withdraw $40,000, then pay 25 percent tax ($10,000), therefore ending up with $30,000 a year. Doing the quick math, at the end of those five years he’d have paid a total of $50,000 ($10,000 a year for 5 years) in income tax, keeping a total of $150,000. Pretty interesting, wouldn’t you agree? But there is a third option available to Junior.

Option 3: The Pension Protection Act of 2006 allows George Junior to do what is known as a “Stretch IRA.” As the name implies, Junior could “stretch” the $200,000 over his entire life expectancy – as determined by Table 1 (Single Life Expectancy for Use by Beneficiaries) in Appendix C of IRS Publication 590. Here’s how that works:

In 2011, George Junior turns 40. According to Table 1, his life expectancy is 43.6 years. Since the value of his inherited IRA (or any other qualified plan, for that matter) at the end of 2010 (the year his father died) was $200,000, he’d divide that by 43.6 to arrive at $4,587. That is the minimum amount he must withdraw in 2011. And if George Junior withdrew this $4,587, he’d owe the IRS $1,147 (25 percent of $4,587) in income-tax, and would therefore end up with a net amount of $3,440. At the end of 2011, his inherited IRA would have a new balance of $195,413 ($200,000 less the $4,587 he withdrew).
Then, come 2012 the amount Junior must withdraw would be based on the ending 2011 balance of $195,413, divided by 42.6 (2011’s divisor of 43.6 reduced by 1 year because he’s now a year older, or 41). That math yields a result of $4,587. So George Junior must now withdraw $4,587, pay 25 percent income-tax (which is $1,147), and end up with $3,440. We are now at the end of 2012, at which point Junior’s inherited IRA is now worth $190,826 – the previous balance of $195,413 less the $4,587 he just withdrew. I recognize that things are really beginning to get interesting, but bear with me a little further and let’s go through the complete scenario – so that you can fully appreciate my viewpoint.
There’s a saying that three times is the charm, so let’s see what happens in 2013. We take the 2012 ending balance of $190,826 and divide by 41.6 (remember, we must reduce it by 1). That amount turns out to be $4,587. With a 25 percent tax ($1,147) George Junior will have a net amount of $3,440 to spend in 2013.
As simple as we have kept our assumptions, I believe you can follow the general direction of what is happening under all three options. The REAL question for debate, though, is whether “Stretch IRAs” provide a tax solution or benefit – because that’s the only reason anyone would pursue them.

In my next column, I’ll share my thoughts on that question, but for now, what do YOU think about the options? By the way, just in case you were wondering whether your age appears on Table 1, it covers every age from zero through 111 years.
Schedule a complimentary session with a licensed professional at Laser Financial Group to discuss whether a stretch IRA may or may not be right for you. or 301.949.4449.

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