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Stretch IRAs: Should You Set One Up?

While good estate tax planning is essential to all wealth management, this is especially true for taking full advantage of an IRA's potential.

September 18, 2008
Sponsored by BNA Software

by Nancy Faussett, CPA

Next to one's primary residence, probably the largest single asset most taxpayers own is their IRA. While good estate tax planning is essential to all wealth management, this is especially true for taking full advantage of an IRA's potential.

While many people have an IRA account to provide income in their retirement years, others enjoy the tax-deferred savings and hope to leave the funds to their beneficiaries. For the latter group, a stretch IRA may be an excellent choice. A "stretch" IRA is a particular type of investment vehicle that is intended to extend, or stretch, the period of tax-deferred earnings for your beneficiaries, while at the same time ease the tax burden from their inheritance. If properly established, stretch IRAs may actually defer earnings for multiple generations and can, therefore, be an excellent tax planning tool.

In the past, a non-spousal beneficiary would often cash out an inherited IRA and pay income taxes on a large sum. Now, if properly handled, IRA funds can continue to grow tax-deferred for a long time. Plus, the beneficiary only has to pay income taxes on the amount withdrawn each year, rather than on a lump sum.

Who Should Create a Stretch IRA?

If you are financially able to retire without depending on the money invested in your IRA, then a stretch IRA may be a perfect fit. This means that even after turning age 70½, when there is an annual required minimum distribution (RMD), you will only withdraw the minimum amount.

Establishing a Stretch IRA

The first step is to designate your beneficiaries. This effectively extends the payment of the required minimum distributions over the beneficiaries' lives. If there are multiple beneficiaries, they generally must begin taking distributions from the IRA based on the life expectancy of the oldest beneficiary. However, the IRA account can be split into separate accounts by December 31st of the year following the participant's death so that the beneficiaries can have their shares distributed over each of their life expectancies.

A word of caution: If someone is entitled to an IRA under the state's intestacy laws, this does not make the individual a "designated beneficiary." The IRA owner must actually name the beneficiary.

The designated beneficiary may be a person or a qualifying trust. In order for a trust to be a designated beneficiary, however, it must be valid under state law, must be irrevocable at the date of death, must have identifiable beneficiaries, and a copy of the trust agreement must be provided to the plan administrator.

Not all financial institutions allow stretch IRAs, so be sure yours does. You should review the institution's custodial agreement for the account. Also, be sure to designate your beneficiary(ies) before you are required to start taking distributions.

How It Works

The IRA owner names their spouse as the sole beneficiary. On the death of the IRA owner, the spouse may then roll over the funds into his or her own IRA and name a new beneficiary for the account, such as a grandchild. When reaching the age of 70½, the surviving spouse only takes the RMD. Once the surviving spouse dies, distributions will be required by the beneficiary(ies).

If the IRA owner's beneficiary is not a spouse, the possible deferment is not as long because the beneficiaries must start taking distributions in the year following the IRA owner's death. (Note that there is no required minimum distribution for the year in which the participant dies.) Whereas a spousal beneficiary can wait until age 70½ to receive distributions, a non-spousal beneficiary cannot. However, the payments to the non-spousal beneficiary will be based on the beneficiary's life expectancy, which can be for an extended period of time. The advantage of this option is that it greatly decreases the amount required to be withdrawn each year, while allowing the account balance to continue to grow tax-free.

A non-spousal inherited IRA must keep the name of the deceased on the account, as in "Joe Generous, beneficiary of Robert Generous." This must be accomplished by December 31st of the year following the participant's death. It cannot be rolled over into the non-spouse's personal IRA. A successor beneficiary can be named for the inherited IRA as long as the distributions from the IRA continue to meet the required minimum distribution rules applicable to the original non-spouse beneficiary.

Example: Mr. Generous dies at age 69 (before required distributions must be made) and his wife, who is 15 years younger, is the sole beneficiary. If Mr. Generous had started contributing when he was 29, he will have deferred taxes on the IRA's earnings for 40 years. At his death, his spouse rolls the IRA into her own IRA and makes their then one-year-old grandson the new beneficiary. The IRA has achieved an additional 15 years of compounded tax-deferred growth due to Mrs. Generous being 15 years younger. Even if Mrs. Generous lives past 70½, she will only take the required minimum distribution each year. At her death, although the grandson must begin withdrawals, he is still quite young and the withdrawals will be small. The funds will continue to grow significantly each year.

Advantages of a Stretch IRA

The principal advantage of a stretch IRA is that it defers taxes for the heirs on the account's balance, allowing tax-deferred growth for a longer period of time.

If the IRA has one's spouse as the sole beneficiary, the marital deduction will shield the account from the estate tax at the participant's death.

A stretch IRA can accumulate a significant financial nest egg for your heirs without any contributions on their part.

Disadvantages of a Stretch IRA

There are several disadvantages of a stretch IRA.

The benefits of a stretch IRA will be diminished if you take more than the minimum distribution starting at age 70½, or if your initial beneficiary does the same.

If the tax laws change, always a risk, your beneficiaries may have more of a tax burden than planned.

Any inflation factor will diminish the returns. Also, there is market risk to assets contained inside of the IRA.

The beneficiaries of a stretch IRA must take required distributions from the IRA. Unless there is reasonable cause for missing a required minimum distribution, the IRS may assess a 50 percent penalty (50% of the distribution that should have been taken).

Also, if liquidity is a problem and some of the IRA funds must be used to pay estate taxes, the income tax deferral benefit will be lost to that extent.

Estate Tax Planning

Because an IRA may be one of the largest assets of an estate, good estate planning for it is important if you want your heirs to receive its maximum benefit.

While there are required minimum distributions once you pass 70½ years, with good planning an IRA can offer tax-deferred savings to your heirs for an extended period of time.

Estate tax planning software can greatly assist you in calculating the required minimum distributions. In fact, the software should allow you to select a spousal rollover for an inherited IRA and then name a beneficiary for the spouse.

Good wealth management and tax planning always go hand in hand.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.