What is a Stretch IRA?

Most individuals utilize Individual Retirement Accounts for retirement income, but there are alternative methods of use. Here's how a stretch IRA can be passed from generation to generation.

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When you’re thinking about your retirement savings, you may have wondered how you could pass your money on to second- and even third-generation beneficiaries. A stretch IRA might be the solution you need.

A stretch IRA isn’t an entirely different type of IRA. Instead, it’s a provision you can add to your current IRA whether it’s a traditional IRA, Roth, SEP IRA, or SIMPLE IRA. A stretch IRA allows your IRA to continue to grow tax-deferred indefinitely because it can be passed from generation to generation.

How to Make a Stretch IRA

To be a stretch IRA, the IRA needs to have two provisions. First, the IRA should allow you to designate a beneficiary who can elect to receive distributions based on a life-expectancy period. Second, the IRA should allow the beneficiary to select a second- or third-generation beneficiary. This is the provision that essentially makes it a stretch IRA.

To avoid an excess accumulation penalty, the primary beneficiary must withdraw a minimum amount each year based on the beneficiary’s life expectancy. The life expectancy of a 48-year-old beneficiary is 36 years, so there would be a $5,000 minimum required distribution on an $180,000 IRA. If that beneficiary passes away prematurely, the second-named beneficiary would continue receiving distributions based on the previous 36-year life expectancy.

The distributions could be stretched out even further if the original IRA owner named a second- or third-generation beneficiary from the start. For example, a 20-year-old beneficiary has a life expectancy of 63 and would receive a minimum $2,857 distribution for 63 years instead of the 36 years in the previous example.

Benefits of a Stretch IRA

Without the stretch IRA provision of making minimum distributions based on life expectancy, beneficiaries will have to receive distributions over a five-year period. In
five years, all the IRA savings must be distributed. (This rule applies when the IRA owner dies before his required minimum IRA distribution (RMD) date, which is April 1 the year after he turned 70 1/2.)

This five-year IRA rule can present problems. The beneficiary may not need all the extra income from the IRA right away. Additionally, accepting higher distributions could increase the beneficiary’s taxable income and push him into a higher tax rate. When
that happens a large percentage – up to 40% in some cases – of the IRA could be lost to federal and state income taxes.

A stretch IRA keeps your assets in the hands of your family and loved ones rather than your estate trustee who will likely pay out the IRA immediately, eliminating the possibility for future tax-deferred growth.

You can make your beneficiary a millionaire. Assuming a 6% rate of return, a $150,000 IRA can pay out more than $1 million over 55 years. The younger the beneficiary, the greater the life expectancy, and the longer the IRA has to grow.

A stretch IRA might be good for you if you won’t need the money in your IRA even after you retire. You must take the lowest amount possible (your required minimum distribution) at the latest age possible (when you turn 70 ½.)

Stretch IRA Watchouts

Unfortunately, tax laws aren’t guaranteed for the next 60 years, so benefits of a stretch IRA are subject to changes in the tax law. At any point in the future, the IRS could change the rules regarding named IRA beneficiaries and minimum required distribution levels.

Your average rate of return should remain fairly constant to receive the highest earnings on your IRA. A fluctuating rate of return will decrease IRA earnings, which means your beneficiaries may not become millionaires, but they still get the advantages of tax-deferred growth from your IRA contributions.