The stretch IRA is a financial strategy that has allowed people to stretch out the life, and therefore the tax advantages of an IRA after it’s inherited. Retirement account owners can name their children or grandchildren beneficiaries of their IRAs or Roth IRAs and these young heirs can stretch out the withdrawals over their own projected lifespan, enjoying decades of extra tax-deferred and/or tax-free growth.
Joe Anderson explains what a stretch IRA is in the clip below
Benefits of A Stretch IRA
A stretch IRA can prove advantageous to beneficiaries by allowing them to defer gains beyond the life of the decedent who initially opened the account. If the entire amount of pre-tax balance in the account were distributed in a single year, the beneficiaries would pay taxes at a potentially higher rate.
Stretching allows for the withdrawal of funds over the life of the beneficiary according to a table, thus potentially providing a substantial reduction in taxes over time. Tax-free accounts can also benefit from a stretch strategy.
While a Roth account can certainly be withdrawn in full once inherited, it is usually beneficial to stretch the account to receive additional tax-free growth of the remaining balance.
(Only non-spouses have Required Minimum Distributions; Roth accounts do not have RMDs during the life of the account holder or their surviving spouse.)
Cons of Using a Stretch IRA
There are disadvantages to using a stretch strategy. Naming a trust as the beneficiary of your IRA can lead to issues if not drafted correctly with a “see-through” or “look through” provision. This is because a trust itself has an age relevant to a required minimum distribution table.
Once a beneficiary inherits a Traditional IRA, they are not able to convert it to Roth status, although this option may be available for inherited defined contribution accounts that have not been rolled over. Check with the specific plan custodian if this is an option before making any decisions if you’ve inherited a 401k or similar account.
One of the principal disadvantages of a stretch IRA is that no matter how advantageous the strategy, your beneficiary may not take advantage of it, instead choosing to take larger distributions than the minimum or even cash the entire account out immediately.
You may wish to discuss the advantages of stretching your IRA with the beneficiaries you’ve selected to ensure that they understand the potential advantages of using the stretch strategy. The process for setting up a beneficiary IRA account can also be confusing, especially for non-spouses.
How To Set Up A Stretch IRA
The process of setting up a stretch IRA depends on your relationship to the decedent. Spouses can take the balance and place it in their own IRA accounts, taking required minimum distributions beginning at 70 ½, but when a beneficiary is a non-spouse, exceptional care must be taken to set up a beneficiary IRA correctly. The account will be titled a decedent or beneficiary IRA for benefit of the named beneficiary.
A non-spouse beneficiary can’t roll balances directly into their own IRA account titled in their name. This is because non-spouses must take required minimum distributions on a different timetable once the account is received, not when they are 70 ½ or older. If this process is not followed accurately, the entire balance incorrectly rolled over can be considered a total distribution. This would mean the full balance is included in taxable income in the year the distribution happens.
The Stretch Survives Recent Tax Legislation
The recent Tax Cuts and Jobs Act has led to substantial changes in our tax code. Not since 1987 during the Reagan administration has there been such comprehensive overall tax reform affecting a variety of aspects of the tax code. Piece by piece legislation has more frequently changed rules related to various aspects of IRA accounts.
Many speculated that the stretch IRA, as well as many other common features of various retirement accounts (indirect Roth contributions, for example), would be eliminated effective 2018 by the new tax legislation. There was also similar speculation that this would occur prior to 2008. The stretch IRA has, however, survived the new tax legislation and is still available to assist account the beneficiaries of account holders in minimizing the tax impact of the account.
IRA accounts are powerful investment tools in general during the life of the account owner. The deferral opportunities are even greater when utilized by subsequent beneficiaries appropriately. With the strategies discussed thus far, you may be able to pass your wealth in the most tax-efficient way to your heirs.