What is a Stretch IRA?
A stretch IRA is an estate planning strategy that extends the tax-deferred status of an inherited IRA when it is passed to a non-spouse beneficiary. It allows for continued tax-deferred growth of an Individual Retirement Account (IRA).
By using this strategy, an IRA can be passed on from generation to generation while beneficiaries enjoy tax-deferred and/or tax-free growth. The term "stretch" does not represent a specific type of IRA; rather it is a financial strategy that allows people to stretch out the life—and therefore the tax advantages—of an IRA.
- Stretching out an IRA gives the funds potentially decades to compound tax-deferred
- Non-spousal heirs must take required minimum distributions (RMDs) based on their life expectancy, so passing the IRA to younger heirs stretches how long it can continue to grow before funds must be withdrawn.
- Stretch IRAs are especially beneficial used with Roth IRAs because distributions are generally tax free.
How a Stretch IRA Works
Stretching out an IRA gives the funds in the IRA more time—potentially decades—to compound tax-deferred. This provides the opportunity to grow the funds significantly for future generations. With a traditional IRA, the owner has to begin taking the required minimum distribution (RMD) by April 1 of the year after turning 70½. The RMD is calculated by taking the account balance on Dec. 31 of the previous year, and dividing that number by the number of years left in the owner's life expectancy (as listed in the IRS' "Uniform Lifetime" table). Each year, the RMD is calculated by dividing the account balance by the remaining life expectancy.
Non-spousal heirs of any age, regardless of the type of IRA, must take RMDs based on their life expectancy (rules for inherited IRAs are different for spouses and non-spouses). The younger the beneficiary, the lower the RMD, which allows more funds to remain in the IRA to stretch the IRA over time. This is why many stretch IRAs are passed to the youngest member of a family.
Stretch IRA: Who Uses Them
In general, wealthier retirees who know that their spouse will have enough money for retirement will use a stretch IRA to maintain their family's wealth by naming the youngest person in their family as a beneficiary. Their minimal RMD taxes will mean that the remaining sum in their IRA will continue to grow tax-deferred. However, not all IRAs allow the stretch strategy, and investors should check with their financial adviser or financial institution to determine if beneficiaries will be allowed to take distributions over a life-expectancy period.
Stretch IRAs are especially beneficial when used with Roth IRAs because distributions are generally tax free, while traditional IRA distributions are treated as ordinary income.
Stretch IRA Developments
In 2016-2017 it was rumored that new legislation would put an end to the stretch IRA and require non-spouse beneficiaries to use a five-year rule for required minimum distributions. But with the passage of the Tax Cuts and Jobs Act, the stretch IRA was given a reprieve.
However, retirement bills making their way through Congress in summer 2019 may limit the use and extent of stretch IRAs. Stay tuned to see if the rules change.