The "stretch IRA" is actually not a type of IRA. Rather, it is a wealth transfer method that involves the IRA—specifically, the beneficiary that you designate to inherit the IRA upon your death. This estate-planning strategy allows you the potential to extend your IRA's distributions over several generations. That's why it's called a "stretch IRA."

Every IRA owner is typically required to designate a beneficiary for the account; this person (or persons) inherits the IRA when you die (assuming there's still money in it, of course). Those fortunate enough to inherit someone else's IRA then have to take required minimum distributions (RMDs) each year from the account, just as you did (assuming you had reached 70½, the age at which the IRS mandates you start making IRA withdrawals).

The amount of the RMD depends on how much is in the account and on age, based on IRS life-expectancy tables. In figuring the RMD, beneficiaries can opt to use the original accountholder's age/life expectancy figure, or their own age. It's usually more advantageous to use their own, since the younger one is, the longer the life expectancy, and the smaller the required distribution.

Key Takeaways

  • The stretch IRA is an estate-planning method that allows you to extend IRA distributions over future generations, thus allowing the IRA to continue to grow.
  • The stretch IRA strategy involves making young people—grandchildren or even great-grandchildren—the IRA beneficiaries, rather than the spouse.
  • The key to the strategy lies in the fact that inherited IRA beneficiaries can take required minimum distributions based on their own age; the younger they are, the smaller the RMD.

How a Stretch IRA Works

Typically, 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 money from the IRA than they really need—and to pay taxes on it, too, unless the IRA is a Roth IRA rather than a traditional IRA. If the spouse and children don't need that extra income, then consider naming those of the next generation (such as grandchildren or great-grandchildren) as the beneficiaries.

Doing so allows you to stretch the value of the IRA out over a longer period of time, and reduces the amount of the taxable withdrawal. At the core of the strategy is the fact that RMDs are based on those life-expectancy tables. Since the grandchildren are younger, the amount they have to withdraw will be much less than the spouse or children would be required to take.

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 the stretch IRA concept in action.

Assume we have a traditional IRA worth $500,000 on 12/31/2019. The original owner was Dave (deceased 12/1/2019).

Let's see how naming the beneficiary changes the size of the distribution that heir will have to take—and therefore, how long the money will be able to continue to grow tax-free and how long it can last before running out.

a) Spouse: Mary (Age 73 in 2020), Mary will have to take an RMD of $20,234 in the year 2020.
b) Son: Mike (Age 55 in 2020), Mike will have to take an RMD of $16,892 in the year 2020.
c) Granddaughter: Julia (Age 28 in 2010), Julia will have to take an RMD of $9,042 in the year 2020.
d) Great-grandson: Dallas (Age 6 in 2020), Dallas will have to take an RMD of $6,519 in the year 2020.

Each beneficiary will have to continue to take the RMD each year thereafter—until the money runs out—based on their new age/new life expectancy figure that must be computed each year from the IRS Publication 590-B from the Appendix B-Life Expectancy Tables section.

If Dave chooses the youngest beneficiary, the RMD outlay can be very small, as will the tax due on it (assuming little Dallas doesn't have much other income). Withdrawing less allows the IRA value to continue to grow tax-deferred, thus allowing it to stretch over several generations.

Advisor Insight

Jack Brkich III, CFP®
JMB Financial Managers, Irvine, CA

A stretch IRA is most commonly used by individuals who aren’t in need of the extra income or who plan to pass on a legacy to heirs in a tax-efficient fashion. These are the pros:

  • A stretch IRA potentially provides a lifetime of income to a beneficiary.
  • 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.
  • 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 beneficiaries receive.

These are the cons:

  • A beneficiary may not live a normal life expectancy.
  • Changes in laws or regulations could have detrimental effects on the owner or beneficiaries.
  • Like any investment, losses or inflation could eat into the value of future distributions.
  • If a beneficiary is a minor, a custodial account or guardianship may have to be established.