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.
- Anne lets the money in the IRA continue to grow tax-deferred. After reaching age 701/2, Anne starts to take her Required Minimum Distributions. By the time she dies at age 80, Anne has netted, after taxes, $92,820 from the account.
- At Anne’s death, Wendy, now age 50, inherits the account, maintains it as a Beneficiary IRA, and names her son Edward as her beneficiary. Wendy begins to receive minimum distributions based on her single life expectancy when she inherits the account, until she dies at age 77. Throughout those 27 years, she receives $371,871 after taxes. However, this is a flexible strategy: Wendy could have withdrawn more at any time if she chose to.
- When Wendy passes away, her beneficiary Edward can choose to continue to receive Wendy’s remaining distributions, which are paid out according to her life expectancy as calculated when the IRA was first inherited from her mother. (Typically, the first non-spouse beneficiary’s life expectancy determines the final maximum distribution schedule.) Edward receives $315,467 after taxes by the time the original IRA is depleted. As was the case with his mother, Wendy, Edward can take more out at any time.
Of course, rates of return, future tax rates, how long owners and beneficiaries will live, and what distribution choices they will make cannot be predicted. But this hypothetical example shows how James’s original $100,000 IRA could potentially yield $780,259 after taxes for three generations of his family. By spreading out, or “stretching,” distributions, James’s beneficiaries extended the life of his IRA so they had the opportunity to grow the assets and minimize their current taxes for as long as possible.
The Stretch IRA strategy can be used not only with Traditional IRAs (rollover or contributory) but also with Roth IRAs. In fact, a “Stretch Roth” that triggers no Required Minimum Distributions for the owner can be an especially attractive option. However, it’s important to note that Required Minimum Distributions are mandatory for anyone but a spousal beneficiary who chooses to roll an inherited Roth IRA to her own Roth IRA, just as they are for an inherited traditional IRA.
How to Avoid the Pitfalls and Reap the Benefits
Individuals who wish to employ the stretch strategy should be mindful of as-yet unrolled retirement plans still with former employers. If an individual dies with assets remaining in a company-sponsored retirement plan, a surviving spouse beneficiary will be allowed to roll the assets over to an IRA, but a non-spouse is not eligible to make a rollover. Many plans mandate that any non-spouse beneficiary is required to receive the assets as a taxable distribution immediately or within five years of the participant’s death, so the opportunity to stretch the payouts over the beneficiary’s life expectancy would be lost.
However, if the assets had been rolled to an IRA prior to the owner’s death and beneficiaries named, any non-spouse beneficiary would be able to leave the inherited assets in a Beneficiary IRA, and then be able to implement a stretch strategy. Depending on the size of the plan, and the projected rate of return, this can represent significantly greater potential future value to beneficiaries.
The benefits of a Stretch IRA for retirees and their families are clear. Moreover, while the basic concept of the Stretch IRA is simple, implementing it can be more complex. Individuals need guidance to make the right decisions about the type of IRA to choose, how to invest assets, which assets from an individual’s estate should be withdrawn first, what the Required Minimum Distributions are, and how to designate beneficiaries. Moreover, they need to understand how the Stretch IRA fits into their overall financial plan and how it can complement their other investments.
As millions of affluent Baby Boomers prepare to retire and begin to think about estate planning, they will need sound advice about their finances in retirements, which offers a tremendous opportunity for financial advisors. In order to make the most of this opportunity, advisors need to have a comprehensive toolkit, and the Stretch IRA is among the most useful and easily-understood strategies advisors can put to work for their clients.
Vicky Schroebel is a business development consultant for MFS Investment Management who has 24 years of financial services industry experience. Based near San Francisco, she holds Series 7, 24, 63, and life insurance licenses, and helps broker/dealers develop and implement strategies that help advisors grow their businesses. She can be reached at AskIRA@mfs.com.