The IRS took the unusual step of permitting a taxpayer to undo a lump-sum distribution from an IRA and avoid the 10 percent penalty for early distributions. The taxpayer, a minor, asked the IRS to allow her to fund an inherited IRA with the previously dispersed funds. Surprisingly, the IRS agreed, and permitted the taxpayer to avoid any income tax or penalties associated with the initial distribution.
IRA Stretch Planning
Unfortunately, the IRS does not reach that kind of ruling very often, so it is essential for us to understand the mechanics of stretch IRA planning. Poor planning can obliterate the value of an IRA, reducing the potential gift by 50 percent or more.
The most important point to remember in IRA planning is that, if a nonspouse beneficiary rolls an inherited IRA into an IRA held solely in the beneficiary's name, the entire amount of the rollover is counted as a distribution and taxed to the beneficiary. Fortunately, there are other options for dealing with inherited IRAs.
In all cases, to avoid being taxed on the inherited account, the IRA should be maintained in the name of the decedent. Then, the timing of required minimum distributions (RMD) from the account will depend on whether there is a "designated beneficiary."
If there is a designated beneficiary and the taxpayer died before the taxpayer's required beginning date, then the beneficiary's RMD is based on the beneficiary's life expectancy. If there is a designated beneficiary and the taxpayer died after the taxpayer's required beginning date, then the beneficiary's RMD is based on the longer of the beneficiary's life expectancy and the taxpayer's life expectancy.
Any individual can be named "designated beneficiary" of an IRA, including not only children, but also grandchildren and even great-grandchildren. Estates, charities, and business entities, however, can't be named as designated beneficiaries.
If there is no designated beneficiary and the taxpayer died before the taxpayer's required beginning date, then the beneficiary must withdraw all of the retirement account within five years of the taxpayer's death. If there is no designated beneficiary and the taxpayer died after the taxpayer's RBD, then the beneficiary's RMD is based on an IRS table that takes into account the deceased taxpayer's life expectancy.
The power of stretch IRA planning is obvious when you consider a simple example.
Example
