Individual retirement arrangement (IRA) accounts come in many flavors:
- Traditional IRA / Rollover IRA
- Simplified Employee Pension (SEP) IRA
- Savings Incentive Match PLan for Employees (SIMPLE) IRA
- Roth IRA / Roth Conversion IRA
Absent from the list above is a stretch IRA – which is not a type of IRA account. Rather, a stretch IRA is a distribution strategy for the inheritors of IRA accounts. For this reason, it may be appropriate to re-name “stretch IRA” to “stretch strategy.”
The stretch strategy focuses on how the owner of an inherited IRA withdraws their money. The strategy proposes to limit withdrawals from an IRA to the minimum required by law. (These minimums for withdrawal are referred to as the “required minimum distribution” – or RMD.) With a stretch strategy, the IRA account is passed from beneficiary to beneficiary, with the only account withdrawals ever being the RMDs. This allows the balance of the IRA account to grow tax-advantaged.
The stretch strategy works because of the tax-advantaged feature of an IRA account; investments inside an IRA account increase in value without any immediate tax consequences. (For Roth accounts, there are no tax consequences.) Taxes are only manifest in the instance of withdrawals (distributions). The stretch strategy takes advantage of this preferential tax treatment by retaining the most assets inside the account as possible.
Per the stretch strategy, the IRA account – and its remaining account balance after any IRS-mandated required minimum distributions (RMD) – is passed from beneficiary to beneficiary. Each time the account moves to a younger beneficiary, the amount of the RMD decreases. This is because younger individuals are subject to smaller RMDs than older individuals (due a younger individual’s longer life longevity).
A stretch strategy is most effective when an IRA is passed not to a child, but a grandchild, or even a great grandchild. Each generation skipped means smaller RMDs, which means a larger balance of the IRA account can grow tax-advantaged. This equates to more value for heirs.
Getting Your Stretch On
In order to successfully execute a stretch IRA strategy, first ensure that your IRA beneficiary designations are up-to-date. You may opt to initially designate your spouse as the beneficiary of your IRA account. Children, grandchildren, or great grandchildren can be listed as contingent beneficiaries. Leaving assets to minors (or those ill-equipped to manage their own assets) presents challenges. This is where designating a trust as a beneficiary may be appropriate. Designating a trust as a beneficiary, however, is a delicate process. If not executed properly, it can result in unfavorable tax consequences.
The stretch IRA is just one of many estate planning strategies available. Just because a strategy may provide a financial planning benefit does not mean that the strategy should be applied universally. In the example of the stretch IRA, one should be cautioned about transferring great wealth to minors.
∙ ∙ ∙
If you are unsure whether a stretch strategy may be appropriate for you, work with a fee-only financial planner. Given the significant complexities, it is highly recommended to consult with a qualified tax professional and estate planning attorney.
∙ ∙ ∙
Learn more about beneficiary designations at our Wealth Analytics Quarterly Webinar next month. Mark your calendar for July 31st at 1:00 p.m. RSVP for our Wealth Analytics Quarterly Webinar on beneficiary designations today by sending us an e-mail at service@WealthAnalytics.com.