After you open an IRA, you need to decide how to invest your contributions. But, other than that, you don't really have a lot of decisions to make. It's a different story, however, once you inherit a traditional IRA. At that point, you need to make some choices - and by making the right ones, you could save thousands and thousands of dollars.
As you probably know, a traditional IRA's earnings grow on a tax-deferred basis, so you pay no taxes on your earnings until you start making withdrawals. But tax deferral also ends at another time - death. So, when you inherit an IRA, you could be facing a big tax hit - if you take the money as a lump sum.
Do you have an alternative? Yes. You could use the money to set up a "stretch IRA,'' which, as the name suggests, includes the flexibility that allows you to stretch out IRA withdrawals - and the subsequent taxes — for as little as a year or over the course of your lifetime. And since you're not liquidating the IRA all at once, it can continue growing over time.
If you decide to establish a stretch IRA, you must begin taking annual distributions by the end of the calendar year following the year of the original IRA's holder's death. (You can calculate your life expectancy, which determines your required annual withdrawals, through a "Single Life Table'' available from the government.)
Furthermore, new Internal Revenue Service rules give you a "second chance'' if you inherited an IRA before 2002. Under the old rules, if you didn't start taking payments by Dec. 31 of the year following the IRA holder's death, you gave up the right to lifetime distributions and had to take them all within five years. But now you've got until Dec. 31, 2003, to take advantage of the stretch IRA provisions. But see your financial and tax experts to find out the specifics to this "second chance."
A stretch IRA can benefit you in some important ways. But it won't happen by itself. For one thing, your parents or other relatives might have their IRA administered by a small bank - which might not even offer the "stretch'' option. So, if you think a family member may be planning on leaving you a traditional IRA, you'll want to check on where it's being held - and possibly move it to a more "stretch-friendly'' place.
Obviously, you can't make such a decision on your own - you'll have to talk with your parents or other relatives about what you'd like to do. In other words, you'll have to plan ahead.
You'll also need to do some advance planning if you're in doubt as to who is listed as the beneficiary of an IRA. Depending on where the IRA is being kept, the assets may go automatically to a surviving spouse or children. This may be acceptable in some cases, but it could prove troublesome if a second marriage is involved. For example, if one of your parents has remarried, then, upon his or her death, the IRA may go directly to the new spouse - even though it was your parent's wish that you receive it.
Clearly, you'll want to find out everything you can about your parents' investments, including the name of the institution administering their IRA and the location of their beneficiary designation forms. While having this type of discussion may seem awkward, you'll actually be helping your parents carry out their wishes - and you'll avoid serious headaches later on.