When looking into retirement investing options, you may have come across the term 'stretch IRA'. This is actually not a category of IRA, such as a Traditional, Roth, SEP or SIMPLE IRA; instead, it is more like a financial-planning or wealth-management concept that acts as a provision of the IRAs many financial institutions offer. A financial institution may not refer to their IRA product by this specific term, so when discussing these IRAs, it may make sense to describe the concept.
The stretch provision is one you might be interested in if you are using your IRA primarily to provide for your beneficiaries. In this article, we'll discuss the stretch concept and the factors that determine whether an IRA includes a stretch provision.
The Stretch Concept
While the basic intent of having a retirement account is to save for and finance retirement years, many individuals have other financial resources and prefer to leave the tax-deferred (or tax-free, in the case of a Roth IRA) assets to their beneficiaries. Whether the beneficiaries can continue to enjoy tax-deferred or tax-free growth on the retirement assets, however, depends on the provisions stated in the IRA plan document.
Some IRA provisions may require the beneficiary to distribute the assets soon after the IRA owner's death. Some will allow the beneficiary to take distributions over his or her life expectancy as provided by the Internal Revenue Code.
Others will allow the beneficiary to distribute the assets over a life-expectancy period and also allow him or her to designate a second-generation beneficiary of the inherited IRA. This provision allowing a beneficiary to designate a second-generation beneficiary (and even a third, fourth and so on) is the one that determines whether the IRA has the stretch provision - it allows the IRA to be stretched (passed on) from generation to generation, if life expectancy allows for it.
How the Stretch Concept Works
As we just stated, the stretch concept allows an IRA to be passed on from generation to generation. However, in doing so, the beneficiary must follow certain rules to ensure he or she doesn't owe the IRS excess-accumulation penalties, which are caused by failing to withdraw the minimum amount each year. Let's explore this further with an example.
Tom\'s designated beneficiary is his son Dick. Tom dies in 2008, when he is age 70 and Dick is age 40. Dick\'s life expectancy is 42.7 (determined in the year following the year Tom died, when Dick is age 41). This means that Dick is able to stretch distributions over a period of 42.7 years. Dick elects to stretch distributions over his life expectancy, and he must take his first distribution by December 31, 2009, the year-end following the year Tom died.
To determine the minimum amount that must be distributed, Dick must divide the balance on December 31, 2008, by 42.7. If Dick withdraws less than the minimum amount, the shortfall will be subject to the excess-accumulation penalty. To determine the minimum amount he must distribute for each subsequent year, Dick must subtract 1 from his life expectancy of the previous year. He must then use that new life-expectancy factor as a divisor of the previous year-end balance.
The IRA plan document allowed Dick to designate a second-generation beneficiary, and he designated his son Harry. If Dick were to die in 2013, when his remaining life expectancy is 38.7 (42.7 - 4), Harry could continue distributions for Dick\'s remaining life expectancy. It is important to note that only the first-generation beneficiary\'s life expectancy is factored into the distribution equation; therefore, Harry\'s age is not relevant.
In this example, Tom could have chosen to designate Harry as his own beneficiary, resulting in a longer stretch period. In such a case, Harry would be the first-generation beneficiary, and his life expectancy instead of Dick\'s would be factored into the equation.
Primary Benefits of the Stretch Concept
The primary benefit of the stretch provision is that it allows the beneficiaries to defer paying taxes on the account balance and to continue enjoying tax-deferred and/or tax-free growth as long as possible. Without the stretch provision, beneficiaries may be required to distribute the full account balance in a period much shorter than the beneficiary's life expectancy, possibly causing them to be in a higher tax bracket and/or resulting in significant taxes on the withdrawn amount.
Generally, the stretch option is not a binding provision, which means the beneficiary may choose to discontinue it at anytime by distributing the entire balance of the inherited IRA. This allows the beneficiary some flexibility should he or she need to distribute more than the minimum required amount.
Benefits for Spouses
A spouse beneficiary is allowed to treat the inherited IRA as his or her own. When the spouse elects to do this, the stretch concept is not an issue, as the spouse beneficiary is given the same status and options as the original IRA owner. However, should the spouse choose to treat the IRA as an inherited IRA, then the stretch rule could apply.
The Bottom Line
If you are interested in having the stretch concept apply to your IRA, consult your current IRA provider or financial institution. If they seem unfamiliar with the term, ask specific questions: will the beneficiary be allowed to take distributions over a life-expectancy period? Will the beneficiary be allowed to designate second- and subsequent-generation beneficiaries? If the answer to these questions is yes, then you are able to use the stretch concept with the IRA.
If the answer is no, then you may want to discuss the possibility of making such allowances with your IRA provider. Most IRA providers would rather make such allowances than have their customer transfer his or her IRA to another financial institution that can accommodate his or her needs. Finally, be sure to consult with your tax and financial professional for assistance with making beneficiary designations that suit your financial profile and your wealth-management goals.