What Is a Stretch IRA?
The stretch IRA is one in which the beneficiary chooses not to distribute the inherited account all at once, but to take required minimum distributions according to his (own) life expectancy. Please refer to my previous post about RMDs.
If you are a non-spouse IRA beneficiary, you have some choices. You can simply sell the assets and distribute them to yourself. This must be done by the end of the fifth year after the IRA owner died. The amount distributed is added to your taxable income for that year, and can run you right up the tax brackets. The taxation sort of makes sense, though, in that the traditional IRA owner was never taxed on the contributions to the account, nor on the growth within the account. So at distribution the IRS gets its own.
Even better, though, is the option of stretching the IRA. This simply means taking required minimum distributions over the beneficiary’s life (beginning the year after inheriting the account). Since the younger beneficiary has a longer life expectancy than the original IRA owner, he or she will be able to “stretch” the life of the IRA by receiving smaller required minimum distributions (RMDs) each year over his or her own life span. With smaller RMDs, more money remains in the inherited IRA, so the account can continue to grow on a tax-deferred basis.
How does the stretch work?
The account balance at the end of the previous year is divided by a factor from a table. Say you are age 50, and you’ve just inherited your dad’s traditional IRA. In the year following his death, you note the balance at the end of last year, and divide it by a factor of 34.2, from a table. If the IRA was valued at $500,000, your RMD for that year is $14,620, which you take on January 2nd. Then let’s assume that the IRA grows by 8% in the next year. The balance at the end of that year will be $524,210. Your subsequent RMD factor at age 51 is 33.3, making your RMD $15,742. Clearly the IRA balance will grow for years to come at the same time that RMDs are being withdrawn!
Please note that these rules apply to non-spouse beneficiaries. The spouse who inherits an IRA has other rules and considerations.
When does the stretch not work?
Clearly, if you don’t have a beneficiary on your IRA, or if your beneficiary has already died. It is so important to keep beneficiary arrangements up-to-date! By the same token, a trust as beneficiary cannot stretch an IRA.
If you’re unlikely to deplete your IRA assets during your lifetime, consider your beneficiary arrangements carefully. A stretch IRA can build long-term financial security for a loved one.