For the latest in Financeware news and Wealthcare resources, please see the last page of this document.

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1 W E A L T H C A R E C A P I T A L M A N A G E M E N T : A D V I S O R E M A I L For the latest in Financeware news and Wealthcare resources, please see the last page of this document. INHERITED IRA: STRETCH-OUT OR CASH OUT? In every affair consider what precedes and what follows, and then undertake it. Epictetus By George Chamberlin The large amount of money invested in qualified retirement plans coupled with the increasing rate of transition of those accounts to heirs of plan participants are the basis for many advisor questions regarding working with inherited IRAs and qualified plan accounts. When coupled with the continued changes in the tax laws the complexity of these questions and the approaches to modeling and analysis have grown dramatically. One of the most commonly heard questions asks whether a client should pursue the stretch-out of tax deferral through an inherited IRA or cash out of the inherited qualified plan account entirely. This article will address some of the considerations and issues in evaluating the proper course of action for these clients. 1 Interestingly, answering the stretch-out question is not as simple as it may appear and it may take some effort to determine what course of action is best suited to a particular client s goals and priorities. The mechanics of the cash out are relatively straightforward as the client will take current distribution of the inherited qualified plan account and pay income tax at the client s tax rate on the account balance. There is no early withdrawal penalty where the inherited account is cashed out following the death of the plan participant instead of maintained as an inherited IRA. Once the tax is paid, the remaining funds may be invested or spent in accord with client goals. The stretch-out presents a somewhat more complicated situation as the inherited qualified plan account will retain its tax advantaged status and income taxes will be assessed only on distributions to the client. The stretch-out beneficiaries are required to begin taking distributions by the end of the year following the year of the plan participant s death, over their individual life expectancies as determined by the single life table. 2 In effect, the amount to be withdrawn will increase each year because remaining life expectancy decreases with the passage of time. The amounts that remain in the inherited IRA continue to benefit from tax deferral until distributed, allowing growth unimpeded by taxation. Understanding that comparing different strategies through modeling helps clients make informed choices among their options, advisors have asked about modeling the stretch-out versus cash out for their clients. Given the complexities of the stretch-out, 100 West Franklin Street, Richmond, VA p f

2 an effective comparative model is somewhat difficult to create because of the differences in the approaches. What are the issues facing us in creating the model and performing a comparison? First, as we typically do in comparing options, a level playing field for the basis of comparison is created by using the same assumptions for each of the tested scenarios - stretch-out and cash out in this case. These would include using the same asset allocation, investment expense, plan duration, tax assumptions, estate goal and the like. Next, most extraneous items are removed, to keep the comparison more transparent and reduce the likelihood of an item skewing the comparison. These would include most cash flows, such as Social Security, pensions, proceeds from the sale of property, education and other spending goals. In addition, increased transparency and accuracy may be achieved if the two scenarios include the inherited account as the sole holding to be analyzed. With the stage set to work with the focus of the comparison, the next step is to model the cash out scenario. The inheritance may be modeled in one of two ways. Either the net after tax value is entered as the current value of a taxable account or we may enter an other source of retirement income flow for the full amount of the inherited qualified plan account as a gross taxable amount. This will ensure the analysis considers the appropriate after tax amount in a taxable account and the chosen allocation will be tested with the account over the planning period. Turning to the stretch-out scenario, the best way to model the inherited account is to enter the whole as a tax-deferred account. The first complication we encounter involves the distributions from the account. Since we are working with an inherited IRA, the client must take a distribution each year, based on his or her life expectancy as established by the single life table. 3 The distribution may be reflected as a gross or taxable withdrawal from the account and may be determined based on the appropriate expectancy from the table. The expectancy is used as the divisor for the account balance and the result is the required distribution. In succeeding years, the original life expectancy is reduced by one to reflect the passage of time, with the result that the proportion of the account that must be distributed in each year will increase. This seems logical enough and we know that the analysis will simulate market performance and the appropriate divisor may be applied to the resulting account balance in each year going forward. However, the withdrawal may not be entered as a dollar amount growing by a specified percentage each year since this will not replicate the actual required distribution. If the analysis is to have any value, we need to be accurate as to the amount of the annual required distribution. We may calculate the percentage of the portfolio that must be withdrawn in each year by applying the appropriate divisor to the account balance and dividing the result by the account balance. The percentage differs each year and this suggests that we would need to enter a series of percentage withdrawals from the portfolio - the inherited IRA account - for each year of the planning period. That sounds like a lot of work to show what must come out of the IRA each year but that is central to any realistic analysis. Inherited IRA: Stretch-Out or Cash Out? January 3, 2007 Wealthcare Capital Management All Rights Reserved PAGE 2

3 At this point, we have modeled a stretch-out scenario that provides a good idea of how the inherited IRA may perform over time as well as the amounts available to the client in the form of the regular required distributions. We have also modeled a separate cash out scenario with the after tax funds being invested and growing over time, with or without withdrawals as may be necessary for the client s particular goals. The question is, however, what we can learn from these two scenarios and how they might be compared. Our comparison illustrates a one million dollar inheritance for a fifty year old client. The planning period is twelve years, lasting until the client s anticipated retirement age of 62. In the cash out scenario, the after-tax value of the inheritance is invested in a taxable account and no withdrawals are anticipated or taken. The stretch-out scenario leaves the entire inheritance in a tax deferred IRA account and provides for the required distributions each year during the planning period. Fig. 1 The table reflects the parameters of the two scenarios modeled. Of particular interest are the percentage withdrawals entered to show the required distributions from the inherited IRA. Their steady increase suggests that later in life the distributions will be quite significant in most cases. The two scenarios use the same balanced allocation and reflect the identical investment expense and rate of inflation. The most instructive view for comparison purposes is the ending wealth graph for the planning period. Fig. 2 Inherited IRA: Stretch-Out or Cash Out? January 3, 2007 Wealthcare Capital Management All Rights Reserved PAGE 3

4 When the client reaches age 62, the two modeled scenarios reflect very similar results. Although it is likely the cash out account will have a larger value at the end of the modeled planning period, the client would not have received the annual distributions that would be generated under the stretch-out alternative. Those taxable distributions would be available to be invested or spent on various client goals over the modeled planning period and evidence some of the value of the tax deferral and stretch-out to the client. However, our analysis does not stop here and there are additional considerations both for modeling and for evaluating the client s options. One concern must be how the client works with the distributions in the stretch-out scenario. In our model, the withdrawal would suggest that the after-tax amount of the distribution is spent. We really can do no more since modeling any reinvestment or savings from these distributions in the same scenario raises a host of issues. We would need to determine how much would be available for reinvestment in any given year, a decision that is uncertain at best. Actual reinvestment would increase the size of the investment portfolio - though not the inherited IRA - but that would skew the calculation of distributions in our model since our percentage withdrawal is taken from the entire portfolio. That works well when the portfolio is the inherited IRA in isolation but not so well when we attempt to model the entire financial picture for the client. This is why we chose to model the inheritance in isolation initially, as an aid to the client and advisor in evaluating the options as opposed to making the inheritance just a piece of the overall strategy. Inherited IRA: Stretch-Out or Cash Out? January 3, 2007 Wealthcare Capital Management All Rights Reserved PAGE 4

5 The stretch-out analysis provides useful information about the anticipated distributions. The report may include the net distributions received each year and when different simulations and percentile rankings are examined, the variations in the actual distributions will be apparent. This information could be employed in the client s overall goal package to reflect the impact of the inherited IRA on the client s financial strategies. For example, the advisor might take the after-tax distribution amounts from an appropriate simulation generated in the stretch-out scenario, such as the eighty-third percentile. These distributions would be entered in the total client analysis for the appropriate years - with any pre-retirement flows reflecting reinvested amounts. The inherited IRA would be omitted as an account since the distributions should exhaust the account over the client s life expectancy. If the client prefers the cash out scenario, then the preferred approach is to add that cash flow at the appropriate time and status, which is much simpler than the stretch-out model. What other considerations might we analyze or discuss with the client evaluating a stretch-out or cash out? First, although the advantages of continued tax deferral are obvious, there are some potential disadvantages to maintaining an inherited IRA that are often overlooked. One is the potential for income tax rates to rise, taking a larger proportion of the distributions in future years. A related point is the fact that capital gains in the account are not taxed until distribution but are then taxed at the often higher ordinary income tax rates. The benefits of tax deferral may outweigh these factors, yet it helps for the client to be aware of the tax implications in order to make an informed decision on how to proceed. Of course, most clients do not live their lives based solely or even primarily on the current income tax consequences of their decisions. In fact, some clients are not interested so much in the tax consequences as in when they can access the money and how much will be available. A second potential disadvantage of the inherited IRA - as opposed to one s own IRA or qualified plan account - is the immediacy of the required distributions. They are not delayed until the client reaches and must be taken sooner. Further, the client s life expectancy is not recalculated as it is under the Uniform Life Table used for other situations. This has the effect of forcing funds out more quickly and that may present a problem later in life where the inherited IRA is substantial and the markets perform any better than the poorer markets modeled in the Comfort Zone range of returns and results. Note that the client who inherits an IRA cannot make contributions to the inherited IRA. This means, of course, that the required distributions cannot be rolled back into the account. It is important to remember that many of these restrictions are attributable to the fact that the inherited IRA was the plan participant s retirement money and now that the plan participant has died, the initial goal of the account is no longer served. Congress permits some continued tax deferral but at the same time forces the money out of the account so that taxes will be paid rather sooner than later. Finally, the client who opts for the cash out approach has complete access to all of the funds remaining after taxes have been paid. There are no forced distributions or other constraints on the use of the funds. They may be passed to heirs or charity freely and may be used for current important goals. The added flexibility bears some cost, of course, in the loss of tax deferral. Inherited IRA: Stretch-Out or Cash Out? January 3, 2007 Wealthcare Capital Management All Rights Reserved PAGE 5

6 Ultimately, the decision to stretch-out or cash out is for the client to make, based on his or her goals and priorities. The advisor using Wealthcare as a means to help the client make the most of his or her one life will be doing the client a service by laying out the alternatives and their impact to the client now and in the future. Evaluating the inherited IRA for stretch-out or cash out. This is the future of financial advising. 1 The treatment of a spousal rollover of an IRA is beyond the scope of our discussion as is discussion of the estate taxes that may come in to play on the death of an IRA owner. 2 Distributions are taken over the fixed life expectancy of the oldest beneficiary where there is more than one beneficiary. These rules are complex and vary with different situations and complete coverage is beyond the scope of our discussion. 3 The single life table may be accessed at ExpectancyTable.html. WEALTHCARE RESOURCES New Whitepaper In our latest whitepaper, Efficiency Deficiency, David Loeper addresses how asset allocation is actually being practiced in today s markets. Click here to open. Careers We are seeking qualified individuals with the ability to communicate our unique advising process both over the phone and in person to advisors with varying levels of financial advising experience as a Wealthcare Support Specialist. Click here for more information. Inherited IRA: Stretch-Out or Cash Out? January 3, 2007 Wealthcare Capital Management All Rights Reserved PAGE 6