The stretch IRA is not actually a type of IRA. Rather, it's a wealth transfer method that involves an IRA—specifically, the beneficiary you designate to inherit your IRA. With this estate planning strategy, you have the potential to "stretch" your IRA's distributions (and tax benefits) over several generations.

Key Takeaways

  • The stretch IRA is an estate planning strategy that lets you extend IRA distributions over future generations—and IRA continues to grow tax-free.
  • With a stretch IRA, you name grandchildren and great-grandchildren as IRA beneficiaries, rather than a spouse.
  • The strategy works because IRA beneficiaries can take required minimum distributions based on their own age. The younger they are, the smaller the RMD, and the longer the account can grow tax-free.
  • Tax laws may soon change the rules for stretch IRAs, which would eliminate the strategy's benefits.

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 like the original account holder did.

The amount of the RMD depends on how much is in the account and on the person's 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 you are, the longer your life expectancy, the smaller the RMD, and the more time the IRA can continue to grow tax-free. That's what makes a stretch IRA a good strategy.

How a Stretch IRA Works

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.

If your spouse and children won't need that extra income, you have the option to skip a generation (or two) and name grandchildren or great-grandchildren as the beneficiaries.

Doing so allows you to stretch the value of the IRA 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 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
Beneficiary Age Life Expectancy RMD
Spouse 75 13.4 $37,313
Child 52 32.3 $15,480
Grandchild 30 53.3 $9,381
Great-grandchild 6 76.7 $6,519

Each beneficiary has to continue to take the RMD each year thereafter—until the money 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-grandson 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.

Pros

  • A stretch IRA potentially provides 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 gives more time for the assets to grow tax-free—which increases the amount beneficiaries receive.

Cons

  • A beneficiary may not live a normal life expectancy.

  • Changes in laws or regulations could have detrimental effects on the owner or beneficiaries.

  • If a beneficiary is a minor, you might have to set up a custodial account or guardianship.

The Bottom Line

A stretch IRA is commonly used by people who want to pass on a legacy to their heirs in a tax-efficient manner. If you're interested in applying the stretch concept to your IRA, consult your current IRA provider.

Depending on the outcome of the SECURE Act vote, the stretch IRA may not be around for long. Stay tuned for updates.