It is ironic that so many people work very hard during their lives to save money and accumulate assets in order to help provide for their family after their death but the potential of these efforts are inhibited by a lack of planning. This happens because wills and powers of attorney are never drawn up and beneficiaries are not named. And if these things are done, they are not kept up to date. As a result your assets don’t get distributed the way you had hoped and the potential financial gains are not realized. In short, your heirs get short-changed.

Most people are aware of the tax benefits of an IRA and Roth IRA, even if that knowledge is somewhat vague. One of the biggest benefits these types of retirement accounts enjoy is that all capital gains, interest, and dividends are earned tax free. What most people are probably not aware of is that this tax benefit can be passed onto the account owners’ beneficiaries. The key word here, however, is beneficiaries. A named beneficiary can continue to have the assets in inherited IRAs and Roth IRAs grow tax free. This can amount to significant gains in the value of the account over the lifetime of the beneficiary even with required minimum distributions. The IRA must be maintained, however, as an inherited IRA and the name of the deceased must appear on the account. If no beneficiaries are named, then these accounts become part of your estate and the tax benefit is lost.

To see how large this benefit potentially can be, let’s consider the following example. An owner of a $100,000 IRA (valued at the end of 2005) passes away in 2005. His son is the beneficiary on the IRA and turns 30 in 2006, the year after his father’s death. The son is required to take minimum distributions each year based on his life expectancy. The son’s life expectancy taken from the 2006 IRS table is 53.3 years. The $100,000 is divided by the 53.3 to determine the required minimum distribution for 2006 of $1,876.17. The next year his life expectancy is reduced by 1 and the account value at the end of 2006 is used to determine the required minimum distribution for 2007. Assuming an annual return of 7%, when the final distribution is taken in the fifty-fourth year, the account will have generated a total of about $960,705 in distributions. This is a simple and very general example of how assets in an inherited IRA can grow. Specific situations may differ depending on the initial value, realized returns, and the distributions taken.

Even if beneficiaries are named, problems develop when they are not kept up to date to reflect changes in your life since the account was established. For example, when you first opened the IRA you may have had two children and named them as beneficiaries and now you have three. Unless the account is up-dated to include the third child, only the first two children will inherit the IRA. This is a fairly common problem when you consider the possibilities of marriage, divorce, births, and beneficiaries predeceasing you. Also you need to remember that the naming beneficiaries supersedes your will and bypasses the probate process. Therefore, even if your will leaves your estate to your current wife or husband, if your ex-wife or ex-husband is still named as beneficiary on your IRA then she or he will inherit the IRA.

Effective in 2007, non-spouse beneficiaries can now transfer balances from other types of qualified retirement plans such as 401(k) plans or Keogh plans into specific IRA accounts and take advantage of the minimum distribution rules for inherited IRAs. Presently only spouses can transfer inherited retirement assets into an IRA. The changes in tax law take effect for distributions that are made beginning in 2007, even if the owner died in 2006. The assets must be transferred directly to an inherited IRA account that has the name of the deceased in the title.

As always when dealing with estate and retirement planning you should consult with your attorney, accountant, and financial planner.

This article is for informational purposes only, and is not meant to be construed as tax or investment advice. SMH Asset Management is a division of Sanders Morris Harris Inc.

Produced by The Financial Planners Association, the membership organization for the financial planning community and is provided by John Conlon, SMH Asset Management (a division of Sanders Morris Harris Inc. member NASD/SIPC),a local member in good standing of the FPA.