The stretch IRA was not actually a type of IRA. Rather, it was a wealth transfer method that involved an IRA—specifically, any non-spouse beneficiary you designated to inherit your IRA. With this estate planning strategy, you had the potential to "stretch" your IRA's distributions (and tax benefits) over several generations. Why do we say "had"?
Because the ability to have and use a stretch IRA ended with the signing, on Dec. 20, 2019, of the spending bills that included the Setting Every Community Up for Retirement Enhancement Act, better known as the SECURE Act.
- The stretch IRA was an estate planning strategy that let you extend IRA distributions over future generations—while that IRA continued to grow tax-free.
- The strategy worked because IRA beneficiaries could take required minimum distributions based on their own age, a particular benefit to grandchildren and great-grandchildren. The younger they were, the smaller the RMD, and the longer the account could grow tax-free.
- The ability to use this strategy ended with the SECURE Act, signed into law on Dec. 20, 2019, which set a mandatory decade-long period to empty IRAs inherited after the end of that year.
- Stretch IRAs already in existence continue under the old rules.
Required Minimum Distributions
If you have an IRA, you'll designate a beneficiary for the account. That beneficiary is the person who inherits your IRA when you die (assuming there's still money in it, of course).
Those fortunate enough to inherit someone else's IRA have to take required minimum distributions (RMDs) each year from the account, just as the original account holder did.
Previously, the amount of the RMD depended on how much is in the account and on the person's age, based on IRS life-expectancy tables. In figuring the RMD, beneficiaries could opt to use the original account holder's age/life expectancy figure, or their own age.
Now, under the SECURE Act, the heir must withdraw the entire IRA inheritance within 10 years of the death of the original account holder, regardless of their age. If the money is being distributed from a traditional IRA, it will be taxable at the recipient's current income tax rate. If it's from a Roth IRA, it won't be taxable.
How a Stretch IRA Worked
Typically, most IRA owners 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 money from the IRA than they really need—and to pay taxes on it, too.
Assuming your spouse and children didn't need that extra income, you once had the option to skip a generation (or two) and name grandchildren or great-grandchildren as the IRA beneficiaries. This tactic spared older family members from the tax burden of receiving the IRA. The grandkids (or whatever non-spouse recipient you designated) still had to take RMDs from the account each year. But the amount could be figured on their age—not that of the original account holder's. Since grandchildren are younger, the amount they would have had to withdraw would be much less than the spouse or children would be required to take.
At the core of the stretch IRA strategy was the fact that RMDs were based on IRS life-expectancy tables. The longer your life, the smaller the annual withdrawal. Young beneficiaries in effect were allowed to stretch the value of the IRA over a longer period of time, reducing the amount of the taxable withdrawal, and allowing the IRA assets more years—even decades—to accumulate tax-free.
The beneficiary of an inherited IRA has until the end of the tax year following the year of the original account holder's death to start taking distributions.
Example of a Stretch IRA
Here's an example to show how the stretch IRA concept used to work. And in this example, it still will work, as the new rules only affect accounts of those who die after Dec. 31, 2019.
Assume we have a traditional IRA worth $500,000 on Dec. 31, 2019. The original account owner passed away on Dec. 1, 2019.
Let's see how naming the beneficiary changes the size of the distribution each potential heir has to take in 2020—and how long the money can continue to grow tax-free (based on life expectancies):
|Stretch IRA Examples|
Each beneficiary has to continue to take the RMD each year thereafter—until the money in the account runs out. This is based on their then-current life expectancy from IRS Publication 590-B.
In our example, if the original account holder named the great-grandchild as the beneficiary, the RMD will be very small, as will be the tax due on it (assuming the six-year-old doesn't have much other income). Withdrawing less allows the IRA balance to continue to grow tax-deferred, thus allowing it to stretch over several generations.
A stretch IRA potentially provided a lifetime of income to a young beneficiary.
The total tax paid may be lower due to smaller distributions over an extended period of time rather than a lump-sum.
Stretching gave more time for the assets to grow tax-free—which increased the amount beneficiaries received.
A beneficiary might not live a normal life expectancy.
Changes in laws or regulations could have detrimental effects on the owner or beneficiaries—exactly what happened with the passage and signing of the SECURE Act on Dec. 20, 2019.
If a beneficiary is a minor, you might have to set up a custodial account or guardianship.
The Bottom Line
A stretch IRA was commonly used by people who wanted to pass on a legacy to their heirs in a tax-efficient manner. With the passage of the SECURE Act, the stretch IRA is no longer permitted when the original account holder dies after Dec. 31, 2019. For beneficiaries already in possession of inherited IRAs, however, the old rules prevail.
Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distribution FAQs."
Morningstar. “New Retirement Law Throws IRA Heirs a Curveball.”
Charles Schwab. “Inherited IRA withdrawal rules.”
Internal Revenue Service. "Publication 590-B: Distributions From Individual Retirement Arrangements," Pages 46-47.