Getting a Good Stretch From Your IRA – Is It Right For You?
Individual
Retirement Accounts (IRAs) continue to be one of the most popular
retirement financial planning instruments. Not only can they provide an
excellent long-term source of income for the IRA owner throughout life,
but they can also stretch the income over the beneficiary’s life
expectancy as well.
A ‘Stretch IRA’ is not a designated type of
IRA. It is a method of estate planning with your current IRA, Roth or
traditional, which helps avoid large, unnecessary distributions to the
IRA owner’s beneficiaries. Its purpose is to extend the life of the
IRA, allowing for a tax-deferred compounding effect in a traditional
IRA and tax-free in a Roth IRA that has incredible growth potential for
the beneficiaries of the account.
In the short-term, the
‘Stretch IRA’ concept does not reduce the traditional IRA owner’s
income as the IRS has provided a Uniform Table for Required Minimum
Distributions (RMDs) which must begin no later than April 1st of the
year following the year the IRA owner turns age 70 ½. Roth IRAs
don’t have a required minimum withdrawal amount for the account owner.
By
utilizing proper beneficiary designations, the long-term advantage,
which applies to both traditional and Roth IRAs, is that the account
owner is ultimately extending the time that the IRA will pay out.
Beneficiaries gain additional deferred years to compound the earnings
growth, therefore, potentially significantly increasing the amount of
that asset over the payout period.
The key advantages of setting up your IRA with a ‘Stretch IRA’ approach are:
-
Beneficiaries enjoy IRA assets that are tax-deferred.
Even while RMD payments are being made to beneficiaries, the bulk of
the assets continue to make gains compounded on a tax-deferred basis.
The amount of the annual RMD that the beneficiary is required to
withdraw is calculated out using the IRA Single Life Expectancy Table.
-
IRA beneficiaries can name their own beneficiaries.
A person who is the beneficiary of an IRA and who is taking RMDs can
name their own beneficiaries for the account. Provided that the account
has not been depleted before their death, those subsequent
beneficiaries are entitled to the assets of the account, fulfilling the
original beneficiary’s single-life expectancy.
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In a Forbes.com article by Deborah L. Jacobs, Brentmark Software calculates an example of the Stretch IRA concept:
Consider
Harry, who leaves part of his IRA, worth $100,000, to his grandson, who
is 21 when Harry dies at age 69. The grandson must begin taking RMDs
the year following Harry's death but can stretch out withdrawals for
the rest of his life. Based on an account balance of $100,000, the
grandson's first required distribution at age 22 is $100,000 divided by
his life expectancy of 61.1 years (from the IRS table), or
$1,636.66.
If
he continues to withdraw just the RMD each year, and the investments
appreciate at a steady rate of 6%, this inheritance will be worth
$342,854 by the time the grandson reaches age 65--and could provide a
tidy nest egg for his own retirement.
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Each
case is different, but individuals who should learn more about a
‘Stretch IRA’ are those who align with one or more of these statements:
- Once
you reach the required beginning date (by April 1 of the year after the
year the IRA owner reaches 70½) to withdraw funds from your
traditional IRA, you wish to withdraw as little as possible.
- You or your beneficiary spouse will not require use of all remaining IRA assets during your lifetimes.
- You would like to reduce and control the amount of taxes on withdrawals made from the IRA.
- It is important to you that you leave a financial legacy to your family.
Beneficiaries
are the key component in setting up a ‘Stretch IRA’. A beneficiary
designation form determines who the recipient of your IRA is. The bank
or financial institution that holds your IRA account, the Custodian,
will be able to supply you with the proper form.
First and
foremost you want to have a “named” beneficiary, i.e., a person or a
trust. The worst thing you can do is name your estate or your
will, as this generally requires the IRA to be exhausted within a
five-year period of time and causes the proceeds to go through
probate. For most married individuals, the primary beneficiary
will be the spouse and the contingent beneficiary will be the
children. This will stretch an IRA over two generations, but by
adding the words “per stirpes” after the children’s name(s), the IRA
can be passed on to grandchildren and perhaps even great-
grandchildren. The IRA owner should consult with his or her
legal, tax, and financial advisor for assistance in setting up the
beneficiary designation.
The most common types of beneficiaries to a ‘Stretch IRA’ approach are:
- Spouse – This approach generally could help eliminate estate tax. The spouse has a few options:
- If
under 59½ - set up an Inherited/Beneficiary IRA. The 10% premature
distribution penalty is avoided but the account is still subject to all
income taxes on the distribution amounts.
- Roll
it into his or her own IRA and then take distributions without penalty
after age 59½ and RMDs beginning no later than April1 after they turn
70½.
- Take
a lump-sum distribution from the IRA. In that event it would be fully
taxable in the year it was received. While this is an option, it does
not support the ‘Stretch IRA’ strategy.
- Decide
not to accept the assets of the IRA. In that case, the spouse would
need to exercise a qualified disclaimer within nine months of the IRA
owner’s death. It would then be passed along to the contingent
beneficiaries. A legal, tax or financial advisor can help with
disclaimers.
- Non-spouse
– This beneficiary CANNOT roll over the IRA assets into their own IRA
or retirement plan. Options for this beneficiary type are as follows:
- If
the IRA is to be left intact, the IRA must be maintained in the name of
the deceased as a Beneficiary or Inherited IRA. A request usually can
be made to directly transfer inherited qualified retirement plan assets
from the qualified plan into the Inherited IRA. This defers taxes on
those assets and increases the amount of the Inherited IRA for better
long-term results.
- May
take a lump-sum distribution from the IRA. The amount would be fully
taxable in the year it was received. Additionally, the beneficiary
could elect to take the IRA over a five year period. These options do
not align with the ‘Stretch IRA’ position.
- Decide
not to accept the assets of the IRA. A qualified disclaimer would need
to be filed within nine months of the death of the IRA owner.
This means the IRA could potentially be inherited by a grandchild of
the IRA owner.
- Multiple Beneficiaries –
- Choose
to divide the IRA into separate Inherited IRA accounts in the owner’s
name before December 31st of the year following the death. RMDs are
then calculated separately based on each beneficiary’s single life
expectancy. Each beneficiary maintains control of those assets,
including naming his or her own beneficiaries. Each beneficiary is then
treated as an individual and follow the above rules.
- Keep
the Inherited IRA as a single IRA in the owner’s name. RMDs are figured
based on the age of the oldest beneficiary. The same timeline of
December 31st of the year following the death applies.
- Trust – The trust must meet certain IRS requirements and special wording in legal documents is generally required.
- RMDs are based on the age of the oldest trust beneficiary’s single life expectancy.
- A
lump-sum distribution can be taken, but, again, fully taxable in the
year of distribution which generally results in a higher tax. This
option does not support the ‘Stretch IRA’ approach.
If
the ‘Stretch IRA’ sounds like a good idea for your personal financial
situation, consult with a qualified professional legal, tax or
financial advisor before making changes to your estate and/or financial
plan. The Custodian of your IRA account can assist you in getting the
required changes made.
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