What Is a Stretch IRA?

A stretch IRA is a way to limit required distributions on an inherited IRA, avoiding a sizable tax bill in the process. Instead of naming his or her spouse as the IRA’s beneficiary, an account holder can name children, grandchildren or great-grandchildren. This stretches the lifespan of the IRA, extending its tax-deferred growth for years or decades beyond the life of the original account holder. Let us explain:

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How the Stretch IRA Works

Say you’ve been diligently saving for retirement for decades. Maybe your IRA has made it into the six figures. Nice work! If you don’t expect to spend down your entire IRA in retirement you may be wondering how to make that money last for your family. One strategy is the stretch IRA.

The rules for inherited IRAs are different for spouses and non-spouse beneficiaries. As a spouse who inherits an IRA you can either rollover the funds to your own IRA or wait to take Required Minimum Distributions (RMDs) until your late spouse would have been 70.5. If you have other income you may want to wait to take RMDs so that your tax bill is lower.

But what about non-spouse beneficiaries? The IRS has stricter rules for non-spouse heirs. These beneficiaries have three options:

1) Take the money and run. This means emptying the entire inherited IRA and paying taxes on that sum in one go. If you really need the money that may be your best bet. Be prepared for a hefty tax bill, though.

2) Take only RMDs. The IRS requires non-spouse beneficiaries of IRAs owned by people over age 70.5 to start taking RMDs within a year of inheriting the IRA. Those RMDs are based on the beneficiaries’ life expectancy. The younger you are, the lower your RMDs.

3) Cash in and empty the account over five years. You don’t have to stick to the minimum RMDs or take all the money from the IRA at once. You can wait and take any sum you want, but once you start taking distributions beyond your RMDs you have to finish emptying the account within five years.

Why Stretch?

The stretch IRA takes advantage of the fact that younger beneficiaries have smaller RMDs. With a stretch IRA, account holders name their youngest relatives as beneficiaries. Well-to-do folks who know that their spouses have enough money to get by can preserve and extend their family’s fortune by naming children, grandchildren and great-grandchildren as IRA beneficiaries. Those younger relatives then take RMDs that are small enough to trigger minimal taxes. The rest of the inherited account can continue to grow tax-deferred and increase in value. It’s a form of inter-generational wealth transfer with serious tax advantages. Not all IRAs can be stretched, so if you’re considering this strategy consult your IRA provider.

If you’re not comfortable bypassing your spouse as your IRA beneficiary you can instruct him or her to stretch for you. With this strategy, you name your spouse as your IRA beneficiary. He or she rolls your IRA into an inherited IRA in his or her name and starts taking RMDs at age 70.5. Your spouse names a member of the younger generation as the IRA’s beneficiary. When your spouse dies, the young beneficiary starts taking the small RMDs described above.

Looking Ahead

The stretch IRA might not be around forever. President Obama included a provision to do away with the stretch IRA in his 2016 budget proposal. Critics of the stretch IRA say that it allows wealthy families to dodge their tax obligations and build up vast family fortunes. If reforms pass, all non-spouse heirs will have to stick to the five-year rule, emptying the inherited account within five years of inheritance.

What happens if the option to stretch an inherited IRA disappears? Some heirs will have to hustle to empty inherited retirement accounts within five years. That means more income for each of those five years, with higher taxes to match. Of course, wealthy families have other ways of minimizing the taxes on family assets. For example, life insurance policies can be passed on to spouses who then owe no estate taxes on the policy pay-out. Backdoor Roth IRA conversion can allow wealthy people to pass tax-free accounts to their beneficiaries. You get the idea.

Bottom Line

When pondering your estate planning needs and strategy, keep this rule in mind: the more you have, the more you should plan if you want to limit your family’s tax liability. Many families consider themselves lucky if they can retire at all. More and more seniors are still dealing with student debt in their golden years. If you’re lucky enough to reach retirement with plenty of money to spare you’re living the dream.

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