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September 01, 2006 at 04:00 AM
Careless treatment of retirement plan assets at the owner’s death could cost beneficiaries hundreds of thousands of dollars in tax-deferred growth. However, even those with moderate wealth can create a significant income stream for their beneficiaries by harnessing the power of the Stretch IRA strategy, a variant on the ordinary Individual Retirement Account. Not only does the Stretch IRA strategy offer tax-deferred growth, retirement income, and legacy planning benefits to retirees and their families, but the concept also provides opportunities to investment advisors who can knowledgeably implement it.
A Stretch IRA is not a different type of IRA. Instead, it is a flexible strategy that can be implemented by any IRA owner. The account holder “stretches out” distributions from the account to maximize the power of tax deferral, which may carry over to more than one generation. The Stretch IRA makes the most sense for those who have other sources of retirement income–from pensions or other investments–and do not need all of their assets to fund their living expenses in retirement.
How the Stretch IRA Actually Works
How does the Stretch IRA work? The concept is simple: The IRA’s owner designates a beneficiary–usually either a spouse or a child. Then the owner withdraws as much or as little from the IRA as needed subject, of course, to the Required Minimum Distribution that the IRS mandates once an account owner reaches age 701/2. To maximize the Stretch IRA’s potential, the owner and subsequent beneficiaries should withdraw as little as possible –ideally, only the annual RMD.
When the owner of the IRA dies, if a spouse has been named as beneficiary, the spouse inherits the assets and may choose to roll them into an IRA in her name, naming her own beneficiary, such as a child. The spouse is then able to take distributions as she sees fit, subject to the RMD limitations mentioned earlier. This can help minimize current income taxes and keep more assets potentially growing in a tax-deferred account. Keep in mind, however, that in addition to income taxes, distributions to a spouse who is under age 591/2 may be subject to a 10% penalty. While distributions to a beneficiary are exempt from the penalty, a spouse who transfers an inherited IRA into her own name is an owner, not a beneficiary.
After the surviving spouse dies, any remaining assets then pass to the named non-spouse beneficiary who would then begin receiving annual distributions based on his own single life expectancy (non-recalculated). The single life expectancy of the non-spouse beneficiary dictates the maximum period over which the distributions could be received. For instance, the IRS tables indicate a 50-year-old beneficiary has a life expectancy of 34.2 years, meaning the non-spouse beneficiary could receive distributions for up to 35 years. If more than one beneficiary is named and the IRA document provides for establishing separate accounts for each beneficiary, each beneficiary can then use his own life expectancy to calculate the period over which the inherited IRA assets can be distributed.
How to Calculate the RMD
The amount the beneficiary needs to take on an annual basis is determined by dividing the previous year-end account balance by the remaining life expectancy of the beneficiary.
If our 50-year-old had inherited an IRA worth $100,000 at the end of last year, the RMD amount would be $100,000 divided by 34.2 years of remaining life expectancy, or $2,924. In future years, the life expectancy factor is reduced by one for each year that passes. This is what is referred to as a “non-recalculated” life expectancy.
Here’s a hypothetical example to show how the Stretch IRA works. The example assumes that the IRA has a 6% annual rate of return, compounded quarterly, and that distributions are taxed at 2005 income tax rates for a single taxpayer:
- James retires at age 65. He has accumulated $100,000 in assets in his company’s retirement plan, which he rolls over into an IRA. He names his wife Anne, age 581/2, as beneficiary. (It’s also a good idea to name a contingent beneficiary at the same time.)
- James dies at age 68 before beginning to receive any distributions from his IRA. Anne rolls his IRA into an IRA in her name and makes her daughter Wendy, age 31, her beneficiary.
