Ask Lynn - This Week’s Column

Baby boomers aren’t optimistic about their chances of inheriting much money from mom and dad. Most Boomers, according to the AARP, don’t expect anything. And those who have already had free money dumped into their laps have pocketed about $48,000. You could blow that amount by making eye contact with a salesman on a car lot.

Most of us aren’t going to inherit a Trump-sized windfall, but that doesn’t mean that what we inherit can’t be financially invaluable. If you’re familiar with the Biblical story of the loaves and fishes, you can appreciate the possibility of turning something that could rattle around inside a shoe box into something that’s exponentially monstrous. You can pull off your own financial miracle if you are ever lucky enough to inherit an Individual Retirement Account.

Here’s the beauty of an inherited IRA: The money nestled inside one of these cocoons can potentially keep growing for decades after the original owner has died. All the IRS requests is that a beneficiary make a modest withdrawal each year. When the money is left largely undisturbed and sheltered from taxes, it’s amazing how fast those dollar bills can replicate.

To appreciate the beauty of an inherited IRA, you need to understand its potential. Let’s suppose that a 45-year-old woman inherits a $50,000 IRA from her mom. Rather than cashing in the IRA and paying income tax, she chooses to stretch her required withdrawals over the next 38.8 years, which is what the IRS says is her life expectancy. If the IRA grows at an average annual rate of 8%, she’d pull out $303,113 before the IRA is depleted.

The value of an inherited IRA is even more stunning when someone receives a jumbo IRA. If the same hypothetical daughter inherited a $500,000 IRA, she’d withdraw a whopping $3,031,136 before it was finally emptied. A grandchild who inherited that IRA and took withdrawals over her life expectancy, would make the $3 million look like the change you’d pocket after ordering a Big Mac.

Unfortunately, many Americans, when they inherit an IRA, don’t appreciate what they’ve got. They ransack the account, pay the taxes and return to bitching about not having enough money.

Whether you expect to inherit an IRA or give one away, here’s some advise to ponder:

Convert to a Roth. Last week I praised the Roth IRA as the superior IRA choice. When you pull money from a Roth during retirement, you won’t owe any taxes. And if you’d rather leave the cash alone, you can. Not so with a deductible IRA. With one of these, you must pay taxes on all withdrawals and you’ve got to start tapping into the account not long after reaching 70 1/2.

Not surprisingly then, a Roth is an infinitely better parting gift for your loved ones. It’s true that a Roth beneficiary will have to make yearly withdrawals–the IRS won’t wait forever for this money to be recycled. But your kids, grand kids, or whoever inherits the cash won’t pay any taxes on the withdrawals. In contrast, anybody who inherits a traditional IRA, will owe income taxes.

If you don’t need your IRA cash and the money is just parked inside one until the kids inherit it, you may want to consider converting it into a Roth. Converting a deductible IRA into a Roth requires that you pay income taxes on whatever amount you decide to convert. You can’t convert to a Roth if your gross adjusted income exceeds $100,000 during the year of the conversion. The same ceiling applies to singles and married couples.

Name the right beneficiaries. Make sure you leave your IRA to the right person! This seems obvious, but people blow it all the time. When you established an IRA at a financial institution, you filled out an IRA beneficiary form. Remember? Actually, most people forget about the form, but it’s important because this piece of paper dictates who receives the cash inside this account when you die. Failing to update the beneficiary form can be disastrous. If you never remove a former spouse from your IRA, for example, it’s the ex who will collect the money. The same thing can happen if you established an IRA years before getting married. If you named your parents or siblings and never changed the designation, your wife or husband won’t get squat. Don’t expect your will to bail you out of this whopper of a mistake. It can’t and won’t.

Roll cash into an IRA. When leaving your job, pack up your 401(k) when you’re emptying out your desk. If the cash is sitting in an IRA, children and grandchildren, who inherit this money, as mentioned earlier, can stretch their withdrawals over their lifetimes. If the money remains in a 401(k), that could be the end of the party. You may have to cash in the account far sooner than you’d like. A widower or widow, however, can transfer 401(k) money into his or her own IRA.

Don’t fumble an IRA hand off. Trying to discern the logic in great swaths of the IRS Code can drive a person into therapy. And here’s one of the code’s great head scratchers: If you inherit an IRA, you must leave the giver’s name on the account. If you substitute your name, the IRS can consider the IRA cashed out and you’d owe applicable taxes on the whole splattered mess. There is one significant exception to this IRA booby trap: If you inherit your spouse’s IRA, you can roll it into your own IRA.

When inheriting an IRA from someone other than a spouse, simply add your name and Social Security number to the account. Be careful if you wish to move mom or dad’s old IRA to the place where you keep your investments. Your parent’s financial institution may suggest cutting you a check, but if you cash the check and then move the money, the IRS will conclude the IRA has been disbanded.

Read more. Hard to believe that someone could write an entire book about IRAs–or would want to. But Ed Slott, a CPA in Rockville Centre, NY, who undoubtedly knows more about IRAs than anybody else I’ve ever interviewed, has done it more than once. You can learn a lot about inheriting IRAs by reading his books, including The Retirement Savings Time Bomb and Parlay Your IRA into a Family Fortune Grab the toothpicks and start reading.

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In life, there are certain things that are beyond indispensable. Like brake lights, hot showers, birthday candles and second chances. And if you’re saving for retirement, the Roth Individual Retirement Account, belongs on that list.

Among all the competing IRAs, the Roth is the alpha dog. That’s because the Roth is more effective than a homicidal pit bull at protecting your cash against one of Americans’ most feared predators — the Internal Revenue Service. When you invest in a Roth and keep the money there until retirement, taxes become somebody else’s problem.

Tax concerns melt away because what’s inside a Roth grows tax free for your lifetime and beyond. If there is money left in your Roth when you die, your heirs, if they are smart enough to know what a fabulous gift they’ve inherited, will prevent this tax-free bubble from bursting. What’s more, the tax protection doesn’t disintegrate if a retiree pulls the cash out. As long as somebody is at least 59 1/2 and has kept cash in at least five years, all withdrawals are tax free.

Of course, the Roth isn’t the only IRA you’ve got. In this beauty contest, the bucktoothed runner up is the deductible IRA. Unlike the Roth, the deductible IRA provides instant gratification. You’re awarded a tax deduction on your income tax return for any contributions you make. How much will depend on the amount you kicked in, as well as your tax bracket. If you invest $4,000 in a deductible IRA this year and you’re in the 15% tax bracket, you’d shave $600 off your federal income taxes. This year, by the way, you can put up to $4,000 into a traditional or Roth IRA and if you’re at least 50, you can toss in another $1,000.

If that tax break caught your eye, you may be wondering why you’d want to walk away from free money. Here’s your answer: When you start draining your deductible IRA during retirement, you’ll be stuck paying income taxes on every withdrawal. Suppose one saver contributed $3,000 a year for 30 year in a Roth and somebody else did the same thing with a deductible. With the hypothetical accounts each earning 8% a year, both investors would end up with more than $359,000. Okay class, you won’t need a calculator for this next question. If our Roth investor cashed in the account, what’s the tax bill? That’s right, it would be zilch.

The IRS, however, would attack the deductible IRA account like it was an all-you-can-eat, steak-and-lobster buffet. If our deductible IRA investor had remained in the 15% bracket, $150 out of every $1,000 withdrawal would belong to the IRS. And in California, there’d be state tax to pay too. The pain would be worse for the more affluent. A guy in the 35% tax bracket, who cashed out that $359,000 would owe $125,650 in federal taxes. Imagine writing that check! And here’s more bad news: the owner of a deductible IRA must begin withdrawals not long after reaching the age of 70 1/2. In contrast, a Roth owner never has to touch his stash.

While the case for the Roth is overwhelming, you wouldn’t necessarily reach that conclusion if you poured over IRA material that is mass produced by financial institutions. Reading the literature, you may assume that picking between a Roth and a deductible IRA is as tortuous as deciding which of your children you love the most. But if you examine how these guys compare the two IRAS, you’ll see that their conclusions about Americans’ spending and investing habits are borderline delusional.

Here’s the scenario that’s often presented in literature. Someone invests $3,000 a year in either a Roth or a deductible IRA. Okay, so far. But then those financial brochures make this huge assumption: The person contributing to the deductible IRA puts the tax savings (Remember that hypothetical $450 tax break?) in a taxable account and lets it ferment like a French Bordeaux until retirement. Now, excuse me, but wouldn’t people choose a deductible IRA so they could get their grubby hands on the tax break right now? If someone receives a refund, isn’t he or she more likely to use this mad money to pay off a credit card, blow it on a weekend trip to San Francisco or buy a PlayStation 2 to shut up a whining kid? If you eliminate the industry’s preposterous scenario, the argument for considering a deductible IRA blows up like a cactus on a weapons testing range.

Now that I’ve hyped the Roth, you should know that not everybody can contribute to one. If you’re a member of the top 1% of Americans that we keep hearing are hogging the recent tax breaks, you can stop reading. This is one cushy tax break that you can’t exploit. Actually, you can’t take full advantage of a Roth IRA if your adjusted gross income exceeds $150,000 (married taxpayers filing jointly) and $95,000 (single taxpayers.) You are eligible for a partial contribution if your income is slightly higher. If you can’t qualify for a Roth, the deductible IRA won’t work either since the income limitations are lower. For those who’ve been shut out, the consolation prize is a nondeductible IRA. With a nondeductible IRA, you don’t get a front-end tax break and you’ll owe taxes on your investment gains when the money’s withdrawn. But the cash remains sheltered from taxes as long as it stays inside the account. Hey, it’s something.

When people start talking to me about IRAs, too often it becomes clear that their knowledge of IRAs could easily fit inside a peach pit. The tip off comes when I ask investors how they’ve invested their IRA. Here’s what I’ve heard many times: “It’s in an IRA investment.” An IRA, however, is only a shell. The account is like an empty Easter basket or a church collection plate that hasn’t been passed around yet. Once you put money into an IRA account, which you can open at just about any financial institution, you then have to decide how to invest it. And what you choose is just as important as deciding which IRA to select.

Imagine how many excuses a cop has heard from speeding motorists and you’ll get some idea of how many investing choices you face. You are free to invest in mutual funds, stocks, bonds, certificates of deposit, money markets and more. It’s usually best to choose mutual funds and, of course, my favorite choices are low-cost index funds.
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