The mysterious Inherited IRA (a.k.a Stretch IRA)

| April 23, 2015

Mike's Blog

Most people have heard of Individual Retirement Accounts or IRAs, but have you heard of the Inherited IRA, sometimes called the “Stretch IRA”? We’re going to examine this mysterious IRA in today’s blog!

To appreciate the value of this special account it’s important to understand that the only person that can roll over a deceased person’s IRA to their own IRA is a surviving spouse. The kids can’t do it, and your grandkids can’t do it. However, the government has provided a solution so your beneficiaries (usually the kids) are not forced to cash out the IRA and trigger unnecessary taxes. This solution is the Inherited IRA which is a very powerful tax shelter for your kids.

The biggest difference between the Inherited IRA and a regular IRA is that the former has required minimum distributions at any age which are taxable. But it’s still far better than cashing the entire IRA out and triggering massive tax losses. These required distributions are based on life expectancy. For example a 30 year old would have a life expectancy of 53.3 years and would have to take out 1/53 the first year from his Inherited IRA, which is about 2%.

The beneficiaries can “stretch out” the distributions over their life expectancy and even over several generations. Here’s the thing: IRAs are allowed to include stretch provisions, but not all do. This is why an Inherited IRA is also called a Stretch IRA. Why is "stretching" so important?

Tax deferral in an IRA can grow significantly. If you don’t need the money, you might want to continue this tax-deferral as long as possible. In fact, you may want your heirs to benefit as well. But the money can't stay in your IRA forever because of minimum distribution rules after your death. The goal of a stretch IRA is for your beneficiary to take payments over the longest period allowed by law. Check your IRA custodial agreement to make sure that it contains the following:

Make sure your IRA provider allows your beneficiary to take payments over their life expectancy. Even though the law allows "stretch out" payments, your specific IRA may not. Your IRA might force your beneficiary to take a fully taxable lump-sum payment, or take it within five years after your death.

If the beneficiary dies early, this is where the IRA language is crucial. Make sure your IRA agreement explains what happens when/if your beneficiary dies. If it does not spell out what happens, or is silent on the matter, then the IRA balance is dumped into your beneficiary's estate and is fully taxable at that time.

IRA providers are getting better at allowing the original beneficiary to name a successor beneficiary. Then the successor beneficiary can "step into the shoes" of your original beneficiary and take over the remaining life expectancy of the original beneficiary. What if your IRA doesn't offer a stretch feature?

It’s simple, move your money to one that does.

By the way: if your spouse is your sole beneficiary, they can combine the deceased person’s IRA to their own IRA and treat it as their own. Then your surviving spouse won't have to start taking distributions until they reach age 70½. Your surviving spouse can name new beneficiaries who can use the stretch later.

An example

Say Jack is 78 years old and dies with a traditional IRA worth $500,000. His surviving wife Mary, age 69 is his sole beneficiary. Mary rolls the IRA her own IRA. Mary names her 44-year-old daughter Susan, as beneficiary. At age 70½, Mary has to take required minimum distributions. At age 79, Mary dies. Susan the daughter, as beneficiary, can stretch payments over her life expectancy, which is 29 years. Susan names her son John age 30, as her beneficiary. Susan dies at age 70 after receiving payments for only 16 of 29 years. She still had 13 years to stretch. John (the son) as beneficiary, is allowed to use up Susan's remaining life expectancy - 13 years.

Under this scenario, earning 6% and taking out the minimum, total payments of over $2 million are made over 40 years to three generations. It can be a very powerful strategy! But it must be done right.

Thanks for reading!

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.