Beware the Many Booby Traps that can Befall IRAs

Lynn O'Shaughnessy
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Posted: May 16, 2006 2:59 PM

People rarely worry about their Individual Retirement Accounts, but perhaps they should. IRAs may seem as threatening as a golden retriever pup, but these accounts have claws and sharp incisors and they'll maul your nest egg if you don't play by their house rules.

In my column last week, I explained why inheriting an IRA can be a financial godsend. If an IRA is stretched for a second or even a third generation, it can often grow three or four times its original size. But many IRAs never last that long because of various booby traps that lie in their path.

Here are a few of the ways to make sure that you or somebody else never sabotages your IRAs:

- Double-check your beneficiaries.

Don't be one of the poor souls who leave their IRAs to the wrong person. You don't want to bequeath your hard-earned money to your ex-spouse, whom you can't even think about without gritting your teeth. You also would never want to intentionally stiff one of your kids or perhaps a grandchild.

Yet it's easy for this to happen. When you establish an IRA, you're supposed to fill out a beneficiary form. But once that document is signed, many people never think about it again. You need to revisit these forms, however, if there is a birth, death, marriage or divorce in the family.

One reason why these beneficiary forms aren't kept current is because people commonly assume that their wills direct who receives their IRAs. But that's a wrong assumption.

If your will says that your present spouse will inherit your IRA, for example, but your IRA beneficiary form still lists your ex-spouse, it's the ex who will strike gold.

If you want to avoid tragic mistakes like that, put this on the new week's to-do list: Obtain your IRA beneficiary forms. Call your financial institution and get copies or simply fill out new forms. When contacting your bank or brokerage firm, you may even discover that the paperwork has vanished. With so many mergers among financial institutions, missing IRA documents are a more common phenomenon than you might imagine. Keep copies of the beneficiary forms in your estate-planning files.

- Aim for the longest stretch.

An inherited IRA's growth can be explosive if a beneficiary only withdraws the minimum amount that's required by the Internal Revenue Service each year.

If you want to capture the longest stretch, you should understand how an IRA can be divided. One way to achieve the maximum stretch is to make sure an IRA gets carved up either before or after the owner's death. Loved ones who inherit an IRA have until Dec. 31 of the year following the death to split an IRA among them.

If the IRA isn't divided into separate shares, all the beneficiaries are stuck with an IRA payout schedule that is based on the age of the oldest beneficiary. Obviously, it would be better for the youngest heirs, who would be forced to drain their portion of the inheritance prematurely, to get this IRA split.

- Don't name your estate as an IRA beneficiary.

If you want your IRA to live long after you're gone, don't designate your "estate" as the beneficiary of your IRA. You may quibble with the IRS rules, but they clearly state that only heirs with a pulse can stretch an IRA.

What will happen if the estate is designated instead? The IRA's fate will depend upon the timing of your death. If an IRA owner dies before he or she begins taking required minimum distributions - this will occur shortly after someone turns 70 1/2 - the IRA must be dissolved at the end of the fifth year following the year of the person's death.

If the owner was already taking required minimum distributions, the heirs could take payments over the deceased's remaining life expectancy. Some financial institutions, however, won't let you keep the IRA on temporary life support and will force you to take the full amount all at once, which will, of course, trigger unwanted income taxes.

- Keep the stretch going for a third generation.

If you were lucky enough to inherit an IRA, take a few minutes to make sure the IRA gets passed on to someone else if you should die before the account is emptied. After inheriting an IRA, you should name a successor beneficiary, who could continue to stretch the IRA for the remaining time on its clock.

For instance, if you had a 30-year life expectancy when inheriting your dad's IRA and you die 20 years later, your daughter, if she was named a successor beneficiary, could continue pocketing the IRA payments for 10 more years. Some custodians will balk at letting you do this, so you'll want to find a financial institution that will cooperate.

- Consult an expert.

Locating someone who is fluent in IRA distribution rules can be as challenging as finding a mall parking space on Dec. 24. Unfortunately, you can't assume that even the nation's best-known financial institutions will provide the right advice.

I've listened to plenty of heartbreaking stories over the years that all share the same theme: Heirs watched their IRAs implode because of terrible advice they received from professionals who should know better.

The latest story I heard came from a reader, who e-mailed me after reading my recent column on botched inherited IRAs. He was the trustee for his sister's estate, which contained more than $1 million in four or five IRAs.

A so-called retirement expert at one of the world's largest mutual fund companies gave him advice that would have blown apart the IRAs. Luckily, he listened to someone more knowledgeable and preserved the accounts.

No certification exists to prove that your investment adviser, broker, estate attorney or the person who answers the phone at your mutual fund company is intimately familiar with IRA rules. Consequently, you're going to have to play detective to get a sense of whether someone is an IRA pro. Here are some questions to ask:

What publications or other resources do you read to keep up with changing IRA rules?

What is IRS Publication 590 and do you have a copy of it?

Do you have a copy of the IRS life-expectancy tables used to calculate IRA required minimum distributions?

Do you attend seminars or read materials by some of the nation's best-known IRA experts?

Here are the people on my short list: Natalie Choate, an attorney in Boston; Robert Keebler, a CPA in Green Bay, Wis.; Ed Slott, a CPA in Rockville Centre, N.Y.; Seymour Goldberg, a CPA and attorney in Melville, N.Y.; Barry C. Picker, a CPA in Brooklyn, N.Y.; Michael J. Jones, a CPA in Monterey, Calif.; Bruce J. Temkin, an enrolled agent in Nashville; and Stephan R. Leimberg, the publisher of Leimberg Information Services Inc. in Haverton, Penn.

- Educate yourself.

Even if you're comfortable with your adviser or estate attorney, you should still understand the IRA basics to protect yourself and your loved ones. I'd recommend two books, both written by Ed Slott: "Parlay Your IRA Into a Family Fortune" (Viking, 2005) and "The Retirement Savings Time Bomb ... and How to Defuse It" (Viking, 2003). He also publishes a monthly newsletter, Ed Slott's IRA Advisor, which contains advice from him and guest IRA experts.