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What Is a Stretch IRA, and How Does a Stretch IRA Work?

The stretch IRA is not actually a type of IRA. Rather, it’s a wealth transfer method that involves an IRA—specifically, any non-spouse beneficiary you designate to inherit your IRA. With this estate planning strategy, you had the potential to “stretch” your IRA’s distributions (and tax benefits) over several generations. Why do we say “had”? Because the ability to have and use a stretch IRA ended with the signing, on Dec. 20, 2019, of spending bills that included the Setting Every Community Up for Retirement Enhancement Act, better known as the SECURE Act.

Key Takeaways

  • The stretch IRA was an estate planning strategy that let you extend IRA distributions over future generations—while that IRA continued to grow tax-free.
  • The ability to use this strategy ended with the SECURE Act, signed into law on Dec. 20, 2019.
  • The strategy worked because IRA beneficiaries could take required minimum distributions based on their own age, a particular benefit to grandchildren and great-grandchildren. The younger they were, the smaller the RMD, and the longer the account could grow tax-free.

Required Minimum Distributions

If you have an IRA, you’ll designate a beneficiary for the account. That beneficiary is the person who inherits your IRA when you die (assuming there’s still money in it, of course).

Previously, the amount of the RMD depended on how much is in the account and on the person’s age, based on IRS life-expectancy tables. In figuring the RMD, beneficiaries could opt to use the original account holder’s age/life expectancy figure, or their own age.

Now the heir must withdraw the entire IRA inheritance within 10 years of the death of the original account holder, regardless of their age. If the money is being distributed from a traditional IRA, it will be taxable at their current income tax rate. If it’s from a Roth IRA, it won’t be taxable, but the recipient will lose the right to have that money continue to grow tax-free in the Roth account.

How a Stretch IRA Worked

Typically, most IRA owners name their spouse as the primary IRA beneficiary and their children as the contingent beneficiaries. While there is nothing wrong with this strategy, it might require the spouse to take more money from the IRA than they really need—and to pay taxes on it, too.

If your spouse and children won’t need that extra income, you have the option to skip a generation (or two) and name grandchildren or great-grandchildren as the beneficiaries. This will still spare older family members from the tax burden of receiving the IRA, but the whole account must now be distributed within 10 years of the death of the original account holder.

The previous stretch IRA rules allowed non-spouse recipients to stretch the value of the IRA over a longer period of time and reduces the amount of the taxable withdrawal. At the core of the strategy was the fact that RMDs were based on IRS life-expectancy tables. Since grandchildren are younger, the amount they would have had to withdraw would be much less than the spouse or children would be required to take.

The beneficiary of an inherited IRA has until the end of the tax year following the year of the original account holder’s death to start taking distributions.

Example of a Stretch IRA

Here’s an example to show how the stretch IRA concept used to work. And in this example, it still will work, as the new rules only affect those who die after Dec. 31, 2019.

Assume we have a traditional IRA worth $500,000 on Dec. 31, 2019. The original account owner passed away on Dec. 1, 2019.

Let’s see how naming the beneficiary changes the size of the distribution each potential heir has to take in 2020—and how long the money can continue to grow tax-free (based on life expectancies):

Stretch IRA Examples
Beneficiary Age Life Expectancy RMD
Spouse 75 13.4 $37,313
Child 52 32.3 $15,480
Grandchild 30 53.3 $9,381
Great-grandchild 6 76.7 $6,519

Each beneficiary has to continue to take the RMD each year thereafter—until the money runs out. This is based on their then-current life expectancy from IRS Publication 590-B.

In our example, if the original account holder named the great-grandson as the beneficiary, the RMD will be very small, as will be the tax due on it (assuming the six-year-old doesn’t have much other income). Withdrawing less allows the IRA balance to continue to grow tax-deferred, thus allowing it to stretch over several generations.

Pros

  • A stretch IRA potentially provided a lifetime of income to a young beneficiary.

  • The total tax paid may be lower due to smaller distributions over an extended period of time rather than a lump-sum.

  • Stretching gave more time for the assets to grow tax-free—which increased the amount beneficiaries received.

Cons

  • A beneficiary might not live a normal life expectancy.

  • Changes in laws or regulations could have detrimental effects on the owner or beneficiaries—exactly what happened with passage and signing of the SECURE Act on Dec. 20, 2019.

  • If a beneficiary is a minor, you might have to set up a custodial account or guardianship.

The Bottom Line

A stretch IRA was commonly used by people who wanted to pass on a legacy to their heirs in a tax-efficient manner. With passage of the SECURE Act, the stretch IRA is no longer permitted when the original account holder dies after Dec. 31, 2019.

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