Stretching Your IRA - A Legacy in the Making

The term "stretch IRA" has become a popular way to refer to an IRA (either traditional or Roth) that has provisions that make it easier to "stretch out" the time that funds can stay in the IRA after the death of the owner. A stretch IRA is not a special type of IRA under the Internal Revenue Code, rather, it's a traditional or Roth IRA that has language in the custodial or trust document that gives a beneficiary or contingent beneficiary the option to take distributions from an inherited IRA over the beneficiary's life expectancy. This language also generally allows for successor beneficiaries to be named, facilitating the further tax-deferred growth of the IRA over (possibly) more than one generation. There's nothing really dramatic about this "stretch" language; any IRA provider can include it. The fact is, though, many don't. Absent the "stretch" language, IRA funds might have to be distributed on a much more aggressive basis upon the death of the IRA owner or original beneficiary.

Why Is Stretching an IRA So Important?

Earnings in an IRA grow tax deferred. Over time, this tax-deferred growth can help an individual to accumulate significant funds in her IRA. For someone fortunate enough to have the funds to support himself in retirement without the need to tap into his IRA, continuing this tax-deferred growth for as long as possible may be a priority. These folks may want for their heirs to benefit from this tax-deferral as well.

As an example, let's say Phred, age 62, has a $400,000 IRA. In addition, having recently retired, Phred has a pension from his former company that pays $40,000 per year, and he has other funds (outside the IRA) that provide an additional $15,000 per year in income. Phred's annual living expenses are (conveniently enough for our example) exactly $55,000 per year. With those circumstances, there is no need to withdraw funds from his IRA until he is required to do so (at age 70 1/2). Phred has named his wife Ethyl, age 60, as the beneficiary (Phred didn't name her Ethyl, her parents named her Ethyl - he only named her the beneficiary!). They have agreed that, should Phred pass away, Ethyl also would not take distributions from the IRA until required (or necessary), with the intention of leaving the balance of the IRA to their grandchildren. Phred dies at age 70, before reaching age 70 1/2. At this point, the IRA has grown to $687,000 (7% per year). Ethyl rolls over the IRA into a new IRA in her name, and does not take a distribution until her age 70 1/2, at which point the IRA has grown to more than $813,000.

Clarifying Two Important Points

Now, a couple of things need to be clear at this point, as the Internal Revenue Code has made this matter quite complicated. The first is that, had Ethyl been under age 59 1/2 and needed the income from the IRA, she could have begun taking distributions of income from Phred's IRA immediately - using his attained age rather than her own. Given that she did not need the funds, though, it was beneficial for Ethyl to roll over the IRA to her own IRA, which allowed for the deferral of the Required Minimum Distribution (RMD) beginning date. It's also important to note that, if Phred were the younger of the two, Ethyl could have deferred that RMD beginning date until the date that Phred would have attained age 70 1/2.

The second point that needs to be clear is that, when Ethyl sets up her rollover IRA, it is critical that the beneficiaries are specifically named on the beneficiary form. The reason for this is that, upon her death, if the beneficiaries are not specifically named, or if the beneficiaries have pre-deceased the IRA owner and subsequent or contingent beneficiaries are not named on the beneficiary form for the IRA, an entirely new set of rules applies (see Non-Designated Beneficiaries below for this explanation).

By naming the beneficiaries specifically, the intentions of the account owner are clear, and will be carried out as she wished. However - if there is more than one beneficiary, it is important to make sure that each beneficiary has had a receiver (rollover) IRA set up and the funds rolled over into the account by the end of the year following the year of death. If these separate accounts have not been established in this timely fashion, the funds must be distributed using the age of the oldest beneficiary as the lifetime. If the accounts are set up as directed though, each beneficiary uses his own age as the lifetime for the distributions.

Meanwhile, Back at the Example...

Continuing our example, let's assume that Ethyl passes away at age 72, having taken two minimum distributions from her account, and the account is now worth over $868,000. She and Phred had three grandchildren as beneficiaries: Chip, age 30, Robbie, age 20, and Ernie, age 10. (I know I'm off on a tangent here, but they had chosen to disinherit their oldest grandson Mike, since he wasn't around any more after the first season.) Since Ethyl had wisely specifically designated the three boys as beneficiaries, each one could draw out the Required Minimum Distributions using their own ages. For Chip, this means that his first distribution would have to be at least $5,431, for Robbie, $4,595, and for Ernie, $3,976. Of course the three boys had had their own separate accounts set up to roll over their inheritances as the law requires. Had they not set up these accounts, all three would have to take distribution of the amount of the oldest beneficiary, Chip. This would mean that Robbie and Ernie would be unnecessarily taking additional (taxable) distributions from the inheritance.

Another way to deal with this would be to set up a trust as the beneficiary of Ethyl's IRA, naming the grandsons as specific beneficiaries of separate trust shares. In this fashion, each would still be able to take distributions over their own lifetimes.

Bear in mind, these beneficiaries are REQUIRED to begin taking distributions upon their inheritance of the IRA proceeds. The only way to defer taking distributions from an inherited IRA is if the beneficiary is the spouse, which we discussed earlier above. Any other person or trust (who is not a spouse) must begin taking distributions upon inheriting the IRA, per their own life, using the Single Life table from the IRS.

Non-Designated Beneficiaries

As mentioned above, if the beneficiary of an IRA is not properly designated on the IRA beneficiary form, a completely different set of rules comes into affect. This situation comes into play when your primary beneficiary pre-deceases you, or if for some reason the original documentation of your beneficiary can not be found (happens more often than you want to know!). This is why it is critical to make copies of your beneficiary designation form, as well as to check up with your IRA custodian to ensure that the proper information is applied to the account. Update these records if your primary or contingent beneficiaries should happen to die before you.

So, if a properly designated beneficiary is not named on the account information, your will (or the state's probate law) will determine the non-designated beneficiary. At that point, if the RMD beginning date for the owner of the IRA has already passed, the beneficiary may take distributions over the remaining life span of the original owner using the Uniform Life table from the IRS. If the RMD beginning date has not passed (that is, the owner of the IRA is less than age 70 1/2), then the non-designated beneficiary must take distribution of the entire account's proceeds within five years of the end of the year in which the account owner died. Obviously, this is not a preferred method, as all of these distributions are taxable as ordinary income, and this five-year method results in very large distributions.

Back to our example - had Ethyl NOT properly designated her grandsons as beneficiaries and had passed away prior to age 70 1/2, each grandson would be required to take distribution of nearly $290,000 within five years of Ethyl's death. Conversely, if Ethyl had attained age 70 1/2 by her death, the boys could stretch out their payments over the Uniform Table's span, amounting to required distributions of just a little over $10,000 to each boy, increasing each year until the account is exhausted.

In a nutshell, that's the stretch IRA. It can be pretty complicated, depending upon your wishes, but in most cases it's not too difficult to work out a proper plan. Hopefully my examples have shown the benefit of properly setting up your IRA beneficiaries, as well as making sure that your wishes and directions are well understood by your heirs and executor. If I can be of any help to you as you set up your IRA to stretch for your heirs, please let me know.