BOSTON (TheStreet) -- While many middle-class Americans are worried about their savings lasting through retirement, the affluent often have a much different concern: how to hand down their excess to heirs.
Ensuring that future generations benefit from hard work and shrewd investments isn't as easy as crafting a will.
Chris Hobart, CEO and founder of Hobart Financial Group in North Carolina, explains that there are four IRA strategies that can be used, with various pros and cons, to ensure a smooth legacy.
Hobart laments that "an IRA is a relatively tax-inefficient transfer of wealth."
The common approach many take, a lump sum distribution, is particularly problematic from a tax standpoint.
"When the beneficiary takes a lump sum, that money is fully taxable to them because it is considered ordinary income," he says. "We can see state and federal taxes of up to about 46% depending on the size of the retirement account. So this is obviously a big mistake."
An added pitfall is that if someone doesn't have their beneficiary account set up properly and IRA assets pass through a trust, estate or will, it will all but guarantee that the benefit will be treated as a lump sum distribution with a high tax rate.STRETCH
A more advantageous approach, geared for those seeking a multigenerational benefit, is typically referred to as either "stretch" IRA planning or legacy IRAs.
This strategy requires a carefully drafted beneficiary statement that clearly states beneficiaries. A spouse is named first, children are secondary and grandchildren third.
"What the children inherit is the remainder of their parents' tax-deferred account, but every year, after mom and dad have passed away, they have to take what is called a 'stretch distribution' or 'minimum distribution' from the account based upon their life expectancy," Hobart says.
Unlike personal or spousal distributions, the children must take immediate annual distributions up to age 85. These start at about 3.6% and grow by 0.5% a year. They are are taxed only on the amount of the distributions, but get to grow the remainder of the account tax-deferred.
True to their "stretch" moniker, this approach adds an even greater tax benefit, because the money is additionally passed on to grandchildren once their parents die.
"The good news is we have just avoided this big tax time bomb," Hobart says. "The bad news is we have also put into our children's lap this fully taxable money, and we don't know where tax rates are going in the future. If everybody is right that tax rates may be going up in the future, even if our kids are only getting minimum distributions we actually might still be giving them money in a tax-hostile environment."