What is the "stretch IRA" concept?
A “Stretch IRA” refers to an inherited IRA It takes an IRA owner several decades to accumulate a large sizeable IRA balance. When he/she passes away, the IRS gives the beneficiaries options to withdraw. When chosen wisely, the original owner’s IRA balance can last a lot longer (a few more decades) in the hands of new and younger beneficiary. Let’s use an example to illustrate what “stretch” means.
Mark dies at age 80; his spouse Sandra, age 75, is the beneficiary. Sandra rolls the benefit into her own IRA and names their only child, Alex, as the beneficiary. During Sandra’s life, the uniform table is used to calculate her RMD (required minimum distribution). At age 76, the applicable distribution period or the factor is 22.0 (see the Uniform Table for individual aged 76). When Sandra dies at 86, Alex becomes the non-spousal beneficiary.
Alex continues to take Sandra’s RMD at her death year, but Alex will use the “Single Life Table” to calculate his own RMD staring the year after his mother’s death. At age 53, the factor used to calculate his RMD is 31.4 (using the “Single Life Table”). Now, Alex can use the account balance as of 12/31 from the year of Sandra’s death and divide 31.4 for his RMD. In subsequent years, the applicable distribution period is the life expectancy from the previous year less one. Using Alex’ example, the factor for the third year RMD is 30.4 (31.4-1), the fourth year is 29.4 (30.4-1), and so forth.
Now the remaining distribution period is fixed, even if Alex dies prior to the end of that time period. His beneficiaries could continue distributions over the remaining period. In this example, the minimum distributions are spread over a 50-year period! This is how an IRA “stretches.” Of course, a beneficiary can take one year or five years to clear up the account, but imagine how much the tax that beneficiary has to pay. Using the stretch method, the beneficiary pays the least amount of tax and preserves the legacy. Best!
It sounds fancy and fun, but the "Stretch" IRA is a fairly simple strategy (not an actual account type). It is a way to defer paying taxes on an inherited IRA by taking distributions over the non-spouse beneficiary’s lifetime. The Investopedia article does a great job of explaining this.
Here is a Sona Financial 90 sec video to help explain it:
It is NOT yet passed, but a bill introduced would do away with the Stretch IRA and require that you take it within 5 years. It is called the Retirement Enhancement & Savings Act Of 2016.
Why Change The Rules?
- Help Fill Government Coffers
- Much like the government doing away with File & Suspend for Social Security
- The overhaul to the government's retirement income program last time was tacked onto the budget bill
- Last Minute!
- Little Debate!
- Will have to liquidate within 5 years
- Exclude $450,000 From the 5-Year Rule
Mark Struthers CFA, CFP®
The "stretch IRA" is not a new IRA account on the market, or even a new investment concept, it is simply a wealth transfer method that allows you the potential to "stretch" your IRA over several future generations. As an IRA owner, you are typically required to take minimum distributions from your IRA at age 70.5 based on an IRS life expectancy table. If you are fortunate enough to inherit someone else's IRA, you will be required to take minimum distributions each year from the IRA account based on your life expectancy figure - regardless of your age.
IRA accounts at death of the owner pass by contract or beneficiary designation. It is typical practice for most IRA owners to name their spouse as the primary IRA beneficiary and their children as the contingent beneficiaries. While there is nothing wrong with this strategy, it might require the spouse to take more taxable income from the IRA than what he/she really needs when he/she inherits the IRA. If income needs are not an issue for the spouse and children-, then naming younger beneficiaries (such as grandchildren or great-grandchildren) allows you to stretch the value of the IRA out over generations. This is possible because grandchildren are younger and their required minimum distribution (RMD) figure will be much less at a younger age (see example below).
Traditional IRA worth $500,000 on 12/31/2009
Owner: Dave (deceased 12/1/2009); *IRA Inherited by:
a) Spouse: Mary (Age 73 in 2010)- Mary will have to take an RMD of $20,234 in year 2010
b) Son: Mike (Age 55 in 2010)- Mike will have to take an RMD of $16,892 in year 2010
c) Granddaughter: Julia (Age 28 in 2010)- Julia will have to take an RMD of $9,042 in year 2010
d) Great Grandson: Dallas (Age 6 in 2010)- Dallas will have to take an RMD of $6,519 in year 2010
*Each beneficiary will have to continue to take the RMD each year thereafter based on the new life expectancy figure which must be computed each year from the IRS Publication 590 (IRA's) from the Appendix C- Life Expectancy Tables section.
If Dave is careful in beneficiary selection, the younger the beneficiary the less the RMD payment. This allows the IRA value to continue to grow tax-deferred, thus allowing it to stretch to several generations.
Find out how your beneficiaries can enjoy tax-deferred growth for as long as possible by referring to Want To Leave Money To Your Family? Stretch Your IRA.
This question was answered by Steven Merkel.
The "stretch IRA" refers to taking advantage of the beneficiary IRA option which can be extremely powerful if used correctly. The "stretch" or "beneficiary" IRA provides an opportunity for a non-spouse IRA beneficiary to take withdrawals based on the beneficiary's age rather than the age of the donor. If the beneficiary is much younger than the the donor (which is usually the case), the RMD (required minimum withdrawal) is a much lower amount. This allows the IRA to continue to grow for much longer and, therefore, continue to grow tax deferred and accumulate more money for the beneficiary.
A Stretch IRA’s main purpose is to extend the period of tax-deferral. It is classified as a wealth transfer strategy that strives to extend the period of time that the assets within the IRA continue to grow tax-free.
This strategy is most commonly used by individuals who aren’t in need of the extra income or who plan to pass on a legacy to their heirs in a tax-efficient fashion.
How does it work?
The owner of the IRA must first name a beneficiary, generally, a spouse, child, or grandchild, and then only the legally required minimum distributions are taken from the account each year.
- Lifelong Income: A stretch IRA could potentially provide a lifetime of income to a beneficiary or beneficiaries.
- Minimized Tax Liability: The total tax paid may be lessened due to taking smaller distributions over an extended period of time rather than as a single lump sum.
- Tax-Deferred Growth: Extending the period of time in which distributions are made lengthens the time in which assets have to grow tax-free and increases the amount that beneficiaries receive.
- Death of Beneficiary: A beneficiary may not live a normal life expectancy.
- Change in Tax Laws: Changes in laws or regulations could have detrimental effects on the owner or beneficiaries.
- Investment Returns: As with any investment, losses or inflation could eat into the value of future distributions.
Setting up a stretch IRA should be considered carefully and with a financial professional because many different factors need to be evaluated.
Best of luck!