IRA is a gift for children that gets better with time



Parents and grandparents leave all sorts of assets to younger heirs, but one with the potential to get significantly better with time is an individual retirement account.

Children or grandchildren who inherit an IRA will be required to take minimum distributions each year from the account so that the money isn't locked up forever. Still, if they let the balance continue to grow tax-deferred in the account for years, if not decades, the rewards can be huge.

How huge?

Take the case of a 1-year-old grandchild who inherits $100,000 in an IRA, according Ed Slott's book, Parlay Your IRA Into a Family Fortune. The toddler must take a minimum amount out of the IRA annually so that 82 years later - her expected lifespan - the account will be depleted.

Even so, if the balance is left to grow at an average annual rate of 8 percent, the IRA would have paid out $8.1 million over the eight decades.

Not a bad legacy.

Of course, many people with IRAs will need the money for their own or a spouse's retirement. And even if they do set up an IRA for a child or grandchild to inherit, there's no guarantee an heir won't cash out the account immediately. "Then all the planning you did is moot," said Jim Thompson, a financial planner in Boston.

Still, for those who can afford it, leaving an IRA to younger relatives is a good way to protect their financial future.

And, the $70 billion tax-cut bill signed by the president last week will make it easier for high-income individuals to convert a traditional IRA to a Roth IRA, which has added benefits for heirs.

Like many things about IRAs, the rules on leaving accounts to children or grandchildren are complex. And IRA owners must proceed cautiously.

"Many of the mistakes can't be fixed after death," Slott said in an interview.

The first step

The first step, and a critical one, is to make sure you fill out the beneficiary form on the IRA with the name or names of those you want to inherit the account, Slott said. If you leave an IRA to your estate or to heirs through a will, they won't be able to stretch out the distributions over their lives, like the example above.

"If you designate a beneficiary, then that gives heirs more options," Slott said.

On the form you can name one or more primary beneficiaries, as well as back-ups in case a beneficiary dies before you do. If there's more than one beneficiary, say how you want the money split among them so there is no confusion or dispute, Slott said. "You give a fraction, or percentage or say `equally,' " Slott said. "Everyone knows who gets what."

Once the account owner dies, a child or grandchild who inherits the IRA must begin taking at least minimum distributions by the end of the next year. So if the IRA owner dies next week, the first distribution must be taken by the end of 2007.

An heir, of course, can always withdraw the entire amount at once. Or, he can take a larger sum than the minimum mandated distribution. But the biggest bang from an IRA comes when heirs take minimum distributions over their lifetime. The IRS lists the life expectancy table in Publication 590.

If there's more than one beneficiary of an IRA, distributions will be based on the age of the oldest. That can largely erase the benefit of stretching out an IRA if one beneficiary is substantially younger than the other - for instance, if one is 10 and the other is 65.

Distribution issues

To avoid this scenario, an IRA owner can split an account before death, designating a single beneficiary for each new IRA. Or, beneficiaries can split an IRA shortly after the owner's death, so that each can take distributions based on his or her own age.

No matter what type of IRA - traditional or Roth - children or grandchildren inheriting the account must take minimum distributions. If they don't, they pay a penalty equal to half the amount they should have withdrawn.

Money coming out of a traditional IRA, though, will be subject to ordinary income tax. Distributions from a Roth IRA are tax-free.

Tax-free withdrawals make the Roth attractive, particularly to those who believe today's growing national debt is a precursor to higher income tax rates in the future.

The new tax law will give more investors an opportunity to own a Roth, and, as a result, pass an account free of income tax onto heirs. "This is a great boon to estate planning," Thompson said.

Under the new law, those with traditional IRAs will be able to convert them to a Roth beginning in 2010 no matter their income. For years, only those with an adjusted gross income $100,000 or less could make such a conversion.

Those who make the switch will have to pay any income tax due on the traditional IRA up front. If they convert in 2010, they can spread the tax bill over 2011 and 2012. If they convert later than 2010, they must pay the entire tax in one year. (This is expected to raise billions in revenue in the short run, lessening the impact of the other tax cuts.)

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