Warming Up into a Stretch IRA

A good "stretch" can make IRA account owners feel better about their legacy planning. 

When it comes to leaving a legacy, one size definitely does not fit all. This is especially true when it comes to bequeathing IRAs to heirs. Different beneficiaries have different situations and needs, making flexibility a desired feature.

A stretch IRA potentially can provide that. As the name would suggest, stretch IRAs have built-in elasticity that enables them to accommodate heirs of different financial shapes and sizes. The objective is to spread out—or stretch—beneficiaries’ distributions over a longer period of time, in order to produce potentially favorable tax and economic outcomes. Utilizing the stretch method can help beneficiaries avoid unnecessarily large, usually taxable distributions.

How much stretch is left in the IRA depends on who inherits it. Generally, older heirs have less stretch than younger ones.

The stretch technique applies only to nonspouse beneficiaries. Spousal beneficiaries have the option of converting inherited IRA assets to their own IRA, making them subject to the rules of a traditional IRA. This means that they are not obligated to start taking required minimum distributions (RMDs) in the year following the account owner’s death, as nonspouse inheritors are required to do. That difference is what makes the stretch option so attractive to nonspouse beneficiaries.

What follows is a rundown of the different payout rules as applied to different beneficiary scenarios: spousal, single nonspousal beneficiary, multiple nonspousal beneficiaries, and trust beneficiaries.

Spousal Beneficiary
Naming a spouse as beneficiary on an IRA is advantageous because only a spouse is permitted to roll over an inherited IRA into his or her own account. The assets then are treated as the spouse’s own IRA and, therefore, are subject to the distribution rules of an IRA.

A second option—again limited only to spousal heirs—is to remain a named beneficiary following the account owner’s death. This may be beneficial if the account owner dies before he/she is required to start taking RMDs at age 70½. As a beneficiary, the surviving spouse can delay required distributions until December 31 of the year in which the deceased spouse would have turned 70½, regardless of the surviving spouse’s age.

If, however, the original IRA owner dies at or after 70½, the surviving spouse, if younger than 70½, probably would be better off making the IRA his or her own and stopping the RMD after the initial payment is made in the year of the original account owner’s death. If the inherited account is a Roth IRA, minimum distributions are deferred until the IRA is left to a subsequent nonspouse benefactor. In other words, a surviving spouse who inherits a Roth IRA is never required to take an RMD.

Example
Larry, owner of a traditional IRA, dies at age 65. His wife Jill, 60, is his sole named beneficiary. Jill, as a spousal beneficiary, can choose the spousal rollover option and treat the inherited IRA as her own. With this option, Jill would not have to take minimum distributions until she reaches 70½. The account would continue to grow tax-deferred for an additional 11 years.

A second option is for Jill to remain as beneficiary. Choosing this alternative offers her the option of deferring minimum distributions until December 31 of the year Larry would have turned 70½. If the inherited account is a Roth IRA, Jill will not be required to take minimum distributions at all, regardless of which of the above options she chose.

Nonspouse Beneficiary
When the owner of a traditional or Roth IRA dies, nonspouse beneficiaries can do one of three things:

▪ Liquidate the IRA. The full amount will be subject to federal and state income tax.

▪ Defer distributions until December 31 of the fifth anniversary year of the account owner’s death     (an option referred to as the "five-year payout" rule).

▪ Begin taking minimum distributions by December 31 of the year following the account owner’s death.

The third option is the stretch option, which allows heirs to stretch distributions over their life expectancy. The option requires the beneficiary to establish an inherited IRA and begin taking distributions no later than December 31 of the year following the account owner’s death, and to continue taking withdrawals over the beneficiary’s lifetime. The distribution payout period, or “stretch,” is based on the life expectancy—as stipulated in the IRS’s Single Life Expectancy Table—of the designated beneficiary (who must be a named person), according to his or her age the year after the account owner’s death.

Although anyone can be a named beneficiary, it’s usually a child or grandchild of the account owner. While the law does not restrict who can opt for a stretch strategy, it perhaps is most suitable for those individuals who wish to leave a legacy for future generations or who are nearing retirement and don’t need their IRA assets for living costs.

Example:
Dennis, a traditional IRA account owner, dies in 2014 at age 55. His son, Darren, 12, is the sole designated beneficiary. Darren can stretch the IRA payout over his life expectancy (69.9 years) based on his age (13) the year after his dad died. Darren must begin taking required distributions by December 31, 2015. In 2016, Darren’s life expectancy is reduced by one year (to 68.9 years), and the RMD is calculated accordingly. This process continues until the account is exhausted.

Darren would be wise to name a successor beneficiary for the same reason as the original account owner: to pass the inherited IRA to a specific individual, thereby allowing for the continuation of the “stretch” feature. It should be noted that the successor beneficiary payout would be determined using Darren’s remaining life expectancy. In other words, the stretch feature can only be calculated once in such cases. Darren, at any time, can withdraw more than the minimum amount. Clearly, redeeming amounts in excess of the RMD will exhaust the account at a faster pace, reducing or eliminating the effectiveness of the stretch strategy.

If the inherited account was a Roth IRA instead of a traditional IRA, minimum distributions would still apply to nonspouse beneficiaries, although the withdrawals would be distributed tax-free. Nonspouse beneficiaries cannot roll over IRA assets to another IRA or workplace retirement plan in their own name.

Multiple Nonspouse Beneficiaries
When an IRA account owner names multiple nonspouse beneficiaries, a different set of payout rules apply. Here, the stretch payout is based on the life expectancy of the oldest beneficiary. This may prove to be an issue if there is a significant age difference between beneficiaries. To avoid this result, beneficiaries can create multiple, separate inherited IRAs, which allows each to use his or her own age to calculate the minimum required distribution. Beneficiaries have until December 31 of the year following the year of the account owner’s death to create their separate accounts.

Example:
Steven, age 75, dies in 2014 with a traditional IRA valued at $300,000. His named beneficiaries are his three sons: Robert, age 50; Richard, 45; and Ernest, 40. If they do nothing, the distributions will be paid out based on Robert’s life expectancy, as he is the oldest. In essence, Richard loses five years and Ernest loses 10 years of additional stretch time. That could translate into a lot of money, given additional time for potential earnings growth on the investments.

However, if the three beneficiaries divide the proceeds into three separate inherited IRAs, each one can stretch out his payments based on their own life expectancy. (See the tables below for an illustration of each scenario.)

The division must take place by December 31, 2015; otherwise, the payout stretch time will default to Robert’s life expectancy. 

Table 1: Multiple Beneficiaries Treating a $300,000 Inherited IRA as a Single Account
Under this scenario, the stretch period for distributions is based on the life expectancy of the oldest beneficiary, Robert.

Source: CalcXML. Based on IRC Regulation 1.40(a)(9). Lordabbett.com/Resources/RetirementCalculators/StretchIRA
*$547,359 represents the total amount paid out to all three beneficiaries over Robert’s life expectancy, assuming everyone simply took the required minimum distribution and our hypothetical 8% earrings rate was achieved.

Table 2: Multiple Beneficiaries Dividing the Single $300,000 Inherited IRA into Three Inherited IRAs
Under this scenario, stretch distributions are based on the life expectancy of the individual account owner. 

Source: CalcXML. Based on IRC Regulation 1.40(a)(9). Lordabbett.com/Resources/RetirementCalculators/StretchIRA.
*$726,695 represents the total amount paid out to all three beneficiaries based on each one’s life expectancy, assuming everyone simply took the required minimum distribution and our hypothetical 8% earrings rate was achieved.
*The hypothetical examples above assume an average annual rate of return of 8%. There is no guarantee that rate will be achieved and if the return is lower, distributions will be commensurately smaller. The illustrations above do not take into account the effect of inflation, which can erode the value of investments over time. They also assume current tax laws remain in effect throughout. If tax laws change in the future, distribution amounts could be different. Due to market volatility, an investor’s actual rate of return will vary and an investor may not experience similar results.

Naming a Trust as a Beneficiary
An IRA account owner also may name a trust as a beneficiary and still preserve the stretch. A word to the wise however: Naming a trust as an IRA beneficiary is one of the most complex and confusing pension-planning topics, and account owners are urged to work closely with their advisors and/or estate planner when designating beneficiaries.

A number of specific IRS requirements must be met for the trust to be considered a named beneficiary (which is necessary in order to qualify for stretch payouts). For starters, the trust must qualify as a “look-through” or “see-through” trust in which at least one individual clearly is identified as the beneficiary of the trust. In addition, all of the trust beneficiaries must be individuals (as opposed to charities, for example); the minimum required distributions then will be based on the age of the oldest trust beneficiary. If the trust does not qualify as a “look-through,” there is no named beneficiary and the stretch option is lost.

The option of dividing accounts into multiple inherited IRAs using each beneficiary’s life expectancy is not permitted when a trust is named as beneficiary. That means the stretch period is based either on the age of the sole named trust beneficiary or, if the trust is among multiple beneficiaries, the age of the oldest heir. The provision permitting a nonspouse beneficiary to establish an inherited IRA also applies to trusts.

Keys to a Successful “Stretch” IRA

▪ Account owners and their advisors should review beneficiary forms at least annually.

▪ Advisors should educate their clients on the power of the “stretch.”

▪ Account owners should be clear on the different payout rules that apply to spouse, nonspouse,, and trust beneficiaries.

▪ Beneficiaries should be clear on their options, including the ability to establish separate inherited IRAs when multiple heirs are designated.

▪ Beneficiaries should always name a successor beneficiary.

▪ Nonspouse beneficiaries of Roth IRAs are subject to RMDs, which they are required to start taking the year following the year in which the account owner died. Payouts are tax-free. 

A Stretch IRA is for investors who will not need their IRA money during their own retirement. While the law does not restrict which tax payers can select the stretch IRA option, the stretch strategy is appropriate only for those individuals who simply need and plan to receive the required minimum withdrawals, taken at the latest time the law allows, without penalty, age 70^1/2.

Withdrawals by the account holder or beneficiaries in excess of the required minimum distribution (RMD) will exhaust the account at a faster pace, reducing or eliminating the effectiveness of the stretch strategy.  Distributions greater than the RMD could subject the payment to higher federal and possibly state income taxes. When investing assets, which will be used to stretch IRA payments, the investor must be cognizant of any front-end or back-end sales charges that can reduce the assets available.  During an extended period of declining investment returns, investors will experience income fluctuations that may cause additional withdrawals to be made that will exhaust the account at a more rapid rate.  There can be no guarantee that a Stretch IRA strategy will be advantageous to your specific situation, and many of its benefits are based on current tax laws, which are subject to change.  If these laws change in the future, an investor’s ability to maintain estimated distributions may be affected.  Lengthy distribution periods, much like those involved in a Stretch IRA, expose an investor to significant market risk.  Consult your financial or tax advisor for more information on Stretch IRAs.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

An IRA rollover may involve the application of fees and charges to the investor.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. The examples presented are hypothetical and are intended for illustrative purposes only.

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.