Stretch IRAs – A Great Way to Pay Taxes Later

Interview with James Lange

Jim (James) Lange, a CPA and estate planning attorney, expounds on the IRA (Individual Retirement Account). What are some of the mistakes that people make with IRAs?

Douglas Goldstein: I am very excited to have on, The Goldstein on Gelt Show, Jim Lange. He’s got over 30 years’ experience as a CPA and an estate planning attorney.

Jim, one of the things that I deal with a lot is that people get inheritances, and in particular when they live in Israel, and they get an inheritance from someone who lived or lives in America, who had an IRA.

People make huge mistakes sometimes when they get the IRA. Could you tell us some of the mistakes people make when getting this kind of inheritance?

Mistakes People Make When They Get an IRA

Jim Lange: The first rule of thumb, Doug, is to think conceptually, which is, “Don’t pay taxes now. Pay taxes later.”

That applies while you are working, and after you’re retired, and even after you die or in the case that you’re talking about, when people inherit an IRA.

Let’s use $1 million as a nice round number. If you inherit $1 million, and remember nobody has paid U.S. income taxes on that money, it doesn’t matter where the person is in the world. They are going to have to pay income taxes on that money.

If they don’t do it intelligently, and let’s say that they pay income taxes, or they don’t plan right and they have to pay income taxes on the $1 million, let’s say they have to write a check for $400,000 to the IRS, now they only have $600,000 left to reinvest.

A much better plan would be to take something called the “minimum required distribution” of the inherited IRA. That’s the government-mandated amount that you must withdraw from an inherited IRA.

That’s based on your life expectancy. Let’s say you have a life expectancy of 40 years. Then you would have to take 40 as the divisor, divide it into the $1 million, and you’d have to take out 2½%.

If you think about it, instead of writing a check to the IRS for $400,000 and only having $600,000 left, you are paying $22,000.

You basically have virtually the entire amount left for reinvestment. You can continue that pattern. That is called the “stretch IRA.” We want people to pay income taxes later, even with inherited money.

Douglas Goldstein: People have to realize that the IRA is just a type of account. It’s a vehicle in which people put their money. In that account, you might have stocks or bonds or mutual funds.

Inside the account, you have many different options but the moment you start to pull the money out, that’s when the taxes are due.

Jim, what I think you’re describing with the stretch IRA is a great opportunity for someone to continue benefiting from a tax-deferred status his whole life, if he got that IRA, let’s say, from a parent.

The Stretch IRA

Jim Lange: Yes they could. Even better, is if the beneficiary is very young, perhaps a grandchild, In which case they can stretch or to some extent defer income taxes not for maybe 30 years of life expectancy, but maybe 60 or 70 years.

The idea, and this current law that we’re talking about, the idea that beneficiaries can defer income taxes on the vast majority of the inherited IRA, is one of the critical planning points.

If you run the numbers, the difference between paying taxes now and paying taxes later on, let’s say $1 million over the lifetime of the beneficiary might be $1 million.

That is if you do it right towards the end of the beneficiary’s life, they will have $1 million. If they do it wrong, they will have nothing. This is not an inconsequential decision.

Douglas Goldstein: I think it’s very critical. One of the things I’ll tell you that people in Israel have a problem with is that someone receives an inheritance, let’s say from a parent in America, and the kid lives in Israel.

He calls up the brokerage firm in America and he says, “I am the inheritor of this IRA. I’d like to keep it in the IRA. I’d like to do a stretch IRA, just like I heard Jim Lange say on The Goldstein on Gelt Show. I’d like to do that. Can you just set it up for me?”

Then the U.S. brokerage firm, because today they are very strict about having clients with addresses overseas, says, “I’m sorry but we’re not allowed to open an IRA for you. You’ll just have to cash out the whole thing today.” That’s a huge problem.

Maybe it is true that that firm won’t open an IRA for you, but others will. Jim, based on what you’re saying, the value at the end of the day to you could be huge.

It’s worth taking the time to figure out how to open the U.S. IRA even if you live overseas.

Jim Lange: Not only that. Not only does the U.S. representative have to set the account up, and as you mentioned, set up an IRA. However, Jews usually don’t name their children after themselves and have Junior, Second, and Third.

Douglas Goldstein: Educational purposes only right?

Jim Lange: Right. I usually use Joe Junior, so Joe Senior dies and then leaves his IRA to Joe Junior. Joe Junior goes to a broker, and let’s say he says to the broker, “I inherited money from my dad and I want you to set it up as an inherited IRA.” The broker says, “Okay, the new name of the account is Joe Junior IRA.”

By doing that, the broker’s made a horrendous mistake that violates one of the rules. Now Joe Junior must pay income taxes on the entire inherited IRA within five years of Joe Senior’s death.

What should have happened is the broker should have titled the accounts, inherited IRA of Joe Senior for the benefit of Joe Junior.

That difference is critical. By the way, this is botched much more often than it’s done right. It should be the inherited IRA of the name of the person who died for the benefit of the person who inherits.

That will enable the beneficiary to continue the stretch or the deferred income taxes on the inherited IRA.

How Is the Inherited IRA Applied?

Douglas Goldstein: Is that applied going from a husband to a wife, or only from a parent to a child?

Jim Lange: No. That will apply to any non-spousal heir, and that might be a child, a grandchild, a partner, a cousin, or somebody else.

With a surviving spouse, there’s a bunch of complicated rules, but the simple thing to do is what’s called a “trustee to trustee transfer.” That way the money is transferred from, let’s say, the deceased husband’s name to the name of the spouse.

There you have a different set of rules, because in that case, the surviving spouse will not have to take any minimum required distributions until he or she is 70.

The spousal beneficiary is treated pretty much like the IRA of the original owner. That is, there is no minimum required distribution till 70.

Then at 70, minimum required distributions kick in. Of course, that has to be done right also, but that is routinely done correctly, whereas the stretch IRA for the non-spouse is routinely botched.

Douglas Goldstein: I think that the takeaway for this is that if you are in the situation and you don’t remember all the details that Jim has been talking to us about, make sure you work with someone who has experience in this.

Double check, because once you mess it up, it’s not like you can go back three years later and say, “I forgot and I coded it wrong. Could you fix it?” Because once it’s set up, Jim, that’s it?

Jim Lange: The problem, of course, is you are exposing yourself to the IRS. The IRS, if you think about it with the new $10.8 million exclusion available to husband and wife for federal estate tax, and the government are needing as much money as they can get.

They are looking after income tax. Frankly, it’s easier to tax dead people than live people. They are looking for these kinds of opportunities.

Douglas Goldstein: Jim, I want to step away from the IRA question for a moment. Because it overlaps with an area that a lot of people talk about. They say, “Who needs all this complication with an IRA? Why don’t I just take the money and put it into an annuity because there it’s tax free, right?”

Is that a recommendation that you give to people?

Isn’t an IRA Overly Complex?

Jim Lange: I’d better watch myself because I’m not a big fan of the traditional commercial annuities, as they tend to have very high fees.

They tend to not be all that tax favorable as you might think. Let’s say you go out and buy an annuity for $100,000. Indeed, it is true that the growth on that annuity will grow tax deferred.

When you take the money out, you have to take it out first on a taxable basis, meaning that you’ll end paying up taxes on the growth. Then when you die with the annuity, all the growth on the annuity is taxable.

My biggest objection, probably, is that I believe that, and against people who have different ideas. I like well-diversified portfolios, where you’re investing in businesses, index funds, or mutual funds.

I tend to not be a huge fan of the traditional commercial annuities.

An Annuity Is Not a Replacement for an IRA

Douglas Goldstein: I don’t think it’s a replacement at all for an IRA. It’s certainly not something that should be put or bought inside of an IRA. Would you agree with that?

Jim Lange: I would agree with that. I think one of the advantages of an annuity is at least the growth is tax deferred.

In an IRA, your investment is tax deferred anyway. I think the only time people end up buying an annuity in the IRA is when the broker wants to sell the annuity because, frankly, he makes a pretty nice commission on it and the client doesn’t have money outside the IRA.

Let’s say your client has $1 million in his IRA and nothing else, and the broker wants to sell a $100,000 annuity, where the only source of money to pay for the annuity is inside the IRA.

Even though it might not be favorable for the client, that’s often what is sold.

Douglas Goldstein: Unfortunately, I’ve seen that happen too. It’s something people have to watch out for. Jim, we’re out of time today. In the last few seconds, tell us how can people follow you and follow your work?

How to Follow James Lange

Jim Lange: If people go to my website, which is www.paytaxeslater.com, they will find a lot of resources, including a book on IRAs and retirement plans.

Douglas Goldstein: Jim Lange, thanks so much for taking the time.

Jim Lange: Thank you.