Make the Best Estate Planning Decision with the Stretch IRA

December 26th, 2015

What if I told you that there is a strategy that allows you to extend the tax-deferred status of your IRA assets? A stretch strategy presents a unique opportunity for heirs of inherited IRAs to withdraw the assets at their disposal over several years across their lifetime. When done correctly, a Stretch IRA presents the option of significantly increasing the amount of money receivable by the beneficiary.

What is a Stretch IRA?

An IRA strategy is basically a distribution strategy, aimed a extending the tax deferred status of your IRA assets over several generations.

How Stretch IRA works during estate planning?

One of the things that you should expect from your estate planning lawyer is some advice on the Stretch IRA. In fact, most lawyers will make this recommendation, and rightfully so for a number of valid reasons. You don’t need to be a mathematician to understand the Stretch IRA, and the estate planning lawyer should ideally be able to easily walk you through the whole strategy. Curious? Here is basically how it works.

The underlying logic is that instead of being given the full sum upon death, your beneficiary receives payment over several years. So for instance, if your IRA is valued at $150,000, you have the option of having the beneficiary receive this money all at once, or to have its spread out. Stay with me on this one. It gets rather interesting.

One of the benefits of the Stretch IRA is that as the beneficiary takes out these small amounts, the money left remains tax deferred, and continues to grow. Given a span of perhaps 45 to 50 years, the beneficiary of your IRA stands a chance of receiving north of a million dollars over that period. More so, if you have a grandchild who is also listed as a beneficiary of the Stretch IRA, these payable amounts become even greater.

Stretch IRA starts with the broader topic of inherited IRA

When the IRA account holder passes on, the account is transferred to the designated beneficiary. The designated beneficiary can either:

  • Transfer the assets to the secondary or continent beneficiary in the event that there is one. In such a situation, the designated beneficiary ‘disclaims’ the assets.
  • Inherits the assets.

The First Option: If the primary beneficiary opts for the first option, then he inherits none of the assets, and they pass over to the contingent beneficiary. The contingent beneficiary can then set up a distribution schedule, in line with his or her own life expected lifespan.

The Second Option: If the primary beneficiary opts to inherit the assets, then he is expected to take on a series of steps. He is expected to re-title the account, as an inherited IRA, under the name of the deceased owner. At no condition is the primary beneficiary allowed to mix the assets with his or her own IRA or other accounts.

Distribution choices for the beneficiary

After the primary beneficiary retitles the account, there are three distribution choices:

  • Take the whole sum all at once, and pay the requisite taxes on the lump sum during that tax cycle, and risk a higher tax bracket.
  • Take the required minimum distributions (RMDs) based on the age of the beneficiary, and thus stretch the distributions of the IRA across the lifetime of the beneficiary.
  • Take a given amount at any given time, but proceed to completely liquidate the account within a period of five years. The beneficiary will pay taxes in the distributions in the year in which they were taken.

How do you Stretch a traditional IRA and Roth IRA

The heir of a traditional IRA is required to pay income taxes on the distribution. The assets that remain in the account are allowed to grow tax free.

For a Roth IRA, the beneficiary does not owe income taxes to any of the distributions, just like the owner. However, this is as long as the account has been open for at least 5 years preceding the first distribution.

Setting up a trust

Despite the numerous benefits of the Stretch option, majority of beneficiaries don’t take it. The result is that majority of the IRAs are completely wiped out within the first year. You however have the option of setting up a trust to encourage your beneficiaries to derive the most from the IRA. There are numerous trusts, and below are a few that are worth considering:

  • Stand Alone IRA Trust
  • Retirement Benefits Trust
  • IRA Stretch Trust
  • IRA inheritance Trust

It is subject to preference whether or not to opt for an IRA Stretch. The truth is that it is really not for everyone. Nonetheless, it is definitely worth considering for discussion next time you set up a meeting with your estate planning lawyer, and definitely a great choice for your estate.