By Beau Ruff

Your traditional Individual Retirement Account, or IRA, is special.

Beau Ruff,

The beauty of the IRA is that a person does not pay income tax on assets going into the IRA. The assets are contributed pre-tax and they grow tax-deferred. It is an effective strategy to both save for retirement and to reduce your current taxable income and thus your resulting tax. And, it can also be implemented to provide asset protection as well. Washington law generally provides that qualified retirement accounts are “exempt from execution, attachment, garnishment, or seizure by or under any legal process whatever.” RCW 6.15.020.

The IRA is a non-probate asset. This means simply that it is not generally distributed according to your last will and testament or your revocable living trust. Rather, it is distributed according to the beneficiary designation associated with the account. Too often, a person seeking to simplify the distribution of his or her estate, names “My Estate” or “According to my Will” as the beneficiary of the IRA. This results in a tax trap for the unwary.

The IRA has many benefits, but the rules associated with the IRA add some complexity. Though the money is not subject to tax when it is placed into the IRA, when the money is withdrawn, it is then subject to income tax. Further, the account holder cannot take the money out of the account before age 59 ½ without paying an additional 10 percent tax penalty (with some exception).

IRAs have a series of rules that revolve around the concept of your required minimum distribution, or RMD. The law requires that, starting at age 70 1/2, the account holder must take out of his or her IRA the RMD which is determined using the account holder’s actuarily-determined life expectancy using tables provided by the IRS. And, that life expectancy is recalculated every year (the IRS recognizes that the life expectancy continues to go up as a person continues to live longer). Thus, we would say that the account holder’s RMD is determined yearly by his or her recalculated life expectancy. For example, a 71-year-old would have a RMD equal to about 3.6 percent of the account value.

Back to the idea of naming “My Estate” as the beneficiary. It is an effective way to enable the last will and testament to control the disposition of the assets and it will effectively direct the asset to your heirs. But, the beneficiary will lose out on the tax-deferred benefit offered by the IRA.

From an income tax point of view, the best way to transfer the IRA is to name your spouse as the beneficiary of the IRA. At the account holder’s death, the surviving spouse can then rollover the IRA into his or her own name and continue to withdraw the RMDs, but now the RMDs would be based on the surviving spouse’s recalculated life expectancy.

The prototypical estate plan gives all assets to the surviving spouse and then splits the assets among the children at the death of the surviving spouse. To continue to receive the best income tax treatment on the IRA that the surviving spouse rolled over into his or her name, the surviving spouse would then name the children as the beneficiary of the IRA. Upon her death, the children would not be able to rollover the IRA, but would receive the asset as an inherited IRA.

When the IRA gets to the second generation (children) through this method, the RMDs are likely still required, but now the children can use their unrecalculated life expectancy to draw out the RMDs. The effect of this is that the children are given a very long period of time to withdraw the assets of the account and thus further delay the tax. This strategy which allows the children to take the IRA out over this maximum period is called the IRA stretch. It’s a powerful tool to incorporate into every estate plan. The reader will note that the children must use their unrecalculated life expectancy versus the more generous recalculated life expectancy available to the surviving spouse.

In the example of making the IRA payable to “My Estate” or “According to my Will” or just providing no beneficiary, then the maximum tax deferral is limited to five years. From a tax standpoint, your heirs are much better off as the named beneficiary.

Sometimes it is necessary to direct the IRA to a trust to protect the asset from creditors or from the heir himself. In this case, the asset protection goals may trump the income tax savings goals. But, rest assured, your estate planning and tax professionals will walk you through the options to provide the best overall asset protection combined with the best possible income tax results.

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Attorney Beau Ruff works for Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick, where he focuses on assisting clients with comprehensive planning.