How To Stretch Out an IRA For Your Beneficiaries

If you don't expect to deplete the assets in an IRA during retirement, then it's a good idea to determine the most efficient way of transferring the account balance to your heirs in a manner that preserves the account's tax-deferred growth potential for as long as possible.

For many Americans, transferring wealth with a multi-generational stretch IRA can be an ideal solution.

By naming a younger individual as the beneficiary, he or she will be able to stretch the life of the IRA by making (smaller) required withdrawals based on his or her (longer) life expectancy.

With a “stretch IRA” strategy, more money can then remain in the IRA with the potential for continued tax-deferred growth.

For those who do not currently have any IRA beneficiaries, the stretch technique could provide significantly greater long-term benefits than simply allowing the account balance to be paid out to your estate as a taxable lump-sum distribution.

Stretch IRAs were made significantly more convenient when the IRS revised the rules governing required minimum distributions (RMDs) from IRAs. Please keep in mind that the required minimum distributions have been suspended for 2009, but will resume in 2010. The three key rule changes affecting stretch IRA allow you to:

Name beneficiaries after RMDs have begun
Change beneficiary designations after the account owner's death
Receive RMDs as a beneficiary that are calculated based on your own life expectancy

Whether you've amassed assets in an individual retirement account (IRA) by making regular contributions through the years or by “rolling over” a lump-sum distribution from a workplace retirement plan, you may want to consider whether it will be necessary to use all of that money to support yourself during retirement. If the answer is “no” (or even “maybe not”) then you'll need to determine the most efficient way of leaving the account balance to your heirs while simultaneously safeguarding your accumulated wealth for as long as possible.

Stretch It Out

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For many Americans, transferring wealth with a multigenerational “stretch” IRA is an ideal solution. A stretch IRA is a strategy for a traditional IRA that passes from the account owner to a younger beneficiary at the time of the account owner's death. 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 life span. More money can then remain in the IRA with the potential for continued tax-deferred growth.

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Creating a stretch IRA has no effect on the account owner's minimum distribution requirements, which continue to be based on his or her life expectancy. Once the account owner dies, however, beneficiaries begin taking RMDs based on their own life expectancies. Whereas the owner of a stretch IRA must begin receiving RMDs after reaching age 70 1/2, beneficiaries of a stretch IRA begin receiving RMDs after the account owner's death. In either scenario, distributions are taxable to the payee at then-current income tax rates.

It's worth noting that beneficiaries also have the right to receive the full value of their inherited IRA assets by the end of the fifth year following the year of the account owner's death. However, by opting to take only the required minimum amount instead, a beneficiary can theoretically stretch the IRA and tax-deferred growth throughout his or her lifetime.

Added Perspectives

Your enhanced ability to stretch IRA assets is a direct result of an IRS decision to simplify the rules regarding RMDs from IRAs. The new rules allow beneficiaries to be named after the account owner's RMDs have begun, and beneficiary designations can be changed after the account owner's death (although no new beneficiaries may be named at that point). Also, the amount of a beneficiary's RMD is based on his or her own life expectancy, even if the original account owner's RMDs had already begun.

Consider the Implications

The ability to name new beneficiaries after RMDs have begun means that you can include a child in your stretch IRA strategy regardless of when the child was born.
The ability to change beneficiary designations after the account owner's death means that one beneficiary may choose to disclaim his or her own beneficiary status so that more assets pass to another beneficiary. For example, if an account owner names his son as the primary beneficiary and his grandson as the secondary beneficiary, the son could remove himself as a beneficiary and allow the entire IRA to pass to the grandson. RMDs would then be based on the grandson's life expectancy, not on the son's life expectancy, as would have been the case if the son remained a beneficiary. (When there is more than one beneficiary, RMDs are calculated using the life expectancy of the oldest beneficiary.)
The ability of beneficiaries to base RMDs on their own life expectancy means that the money you accumulate in your IRA and leave to heirs has the potential to last longer and produce more wealth for younger generations. (See example.)

Keep in mind that this information is presented for educational purposes only and does not represent tax or financial advice. While it is true that recent regulatory changes have indeed made it much easier to incorporate a stretch IRA into your multi-generational financial planning initiatives, it's always a good idea to speak with a tax professional before implementing any new tax strategy.

Stretch IRA in Action

Assume that you leave a $100,000 IRA to a five-year-old beneficiary who has an estimated life expectancy of 77.7 years, according to current IRS life expectancy tables.