Posted by Fred Lake

What You Should Know About Stretch IRAs

What You Should Know About Stretch IRAs

A stretch IRA is a means of limiting required distributions on an inherited IRA when then helps avoid a sizable tax bill in the process. An account holder can name children, grandchildren or great-grandchildren instead of naming his or her spouse as the IRA’s beneficiary. The IRA’s lifespan is therefore stretched which causes its tax-deferred growth to extend for years or decades beyond the original account holder’s life. Allow us to explain this to you further below.

For instance, you’ve been saving for retirement diligently for decades. Let’s say your IRA has made it into the six figures. Well done! You may be wondering how to make your money last for your family if you don’t expect to spend down your entire IRA in retirement. A strategy you may find useful is the stretch IRA.

What is the Stretch IRA?

There are different rules for inherited IRAs when it comes to spouses and non-spouse beneficiaries. You, as a spouse who inherits an IRA, can either roll over the funds to your own IRA or wait until your late spouse would have been 70.5 to take Required Minimum Distributions (RMDs). Your tax bill is lower if you choose to wait to take RMDs if you have other income.

The non-spouse beneficiaries have stricter rules as imposed by the IRS. There are three options give to these beneficiaries:

1. Take the money and leave. This means you take the entire inherited IRA and pay taxes on that sum in one go. This could be your best bet if you really need the money although you’ll have to be prepared for a hefty tax bill.

2. Only take RMDs. Non-spouse beneficiaries of IRAs owned by people over age 70.5 are required by the IRS to start taking RMDs within a year of inhering the IRA. The basis of those RMDs is the beneficiaries’ life expectancy. You get lower RMDs the younger your age is.

3. Cash in and take all of the amount over five years. Sticking to the minimum RMDs or taking all the money from the IRA at once doesn’t have to be your only option. You can also wait and take any sum you want. However, once you start taking distributions beyond your RMDs, it’s required that you finish emptying the account within five years.

Why Should You Stretch?

The stretch IRA knows the younger beneficiaries have smaller RMDs, so it’s taking advantage of it. Account-holders name their youngest relatives as beneficiaries with a stretch IRA. For people with money who know their spouses have enough money to survive and extend their family’s fortune by naming children, grandchildren, and great-grandchildren as beneficiaries for their IRA. The RMds that are small enough to trigger minimal taxes is then taken by those younger relatives. The rest of the account that was inherited keep on growing tax-deferred and increase in value. As you can see by now, it’s a type of inter-generational wealth transfer with a good amount of tax advantages. If you’re considering this strategy, consult your IRA provider since not all IRAs can be stretched.

You can instruct your spouse to stretch for you if you’re not comfortable bypassing your spouse as your IRA beneficiary. You get to name your spouse as your IRA beneficiary with this strategy. Your spouse can roll IRA into an inherited IRA in his or her name and at the age of 70.5 can start taking RMDs. Your spouse then assigns a member of the younger generation as the IRAs beneficiary. The young beneficiary starts taking the small RMDs described above when your spouse dies. 

Stretch IRA in the Future

The stretch IRA might not be around for too long. President Obama’s 2016 budget proposal included a provision to do away with the stretch IRA. According to the critics of the stretch IRA, wealthy families are able to dodge their tax obligations and build up huge family fortunes. All non-spouse heirs will have to stick to the five-year rule if reforms pass, emptying the account that was inherited within given years of inheritance. If stretch IRA disappears, some heirs will have no choice but to empty retirement accounts within five years. Therefore, more income for each of those five years matching higher taxes. 

Fred Lake
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