Stretch IRAs are useful tools for the individual who wants to extend the life of their retirement accounts through multiple generations. Although there is often confusion surrounding stretch IRAs and how they work, the concept is straightforward. A stretch IRA is a strategy, not a product, used to “stretch” the life of Roth IRA and Traditional IRA assets by designating beneficiaries with the longest life expectancy, such as grandchildren or even great grandchildren. By selecting beneficiaries two to three generations younger than the account owner, as opposed to designating children, the IRS will have lower imposed required minimum distributions (RMDs) for the inherited IRA, leaving a greater asset base to grow and cover future distributions.
To calculate the RMD for an inherited IRA (Table 1 – IRS Single Life Expectancy Table), divide the previous year-end account balance by the divisor (beneficiary’s life expectancy) corresponding to their respective age in the year following the death. This divisor is the IRS’s actuarial-based remaining life expectancy for the beneficiary, so each year, the divisor will decrease by 1, causing an increase in the percent of the account balance taken for the RMD.
The IRS provides a list of distribution options available to inherited IRA owners. Distribution options vary depending on whether the beneficiary was a spouse or non-spouse, and also whether the IRA owner passed away before their required beginning date (RBD), which is April 1 after they turn 70½.
- Treat it as his or her own with the option to roll the IRA into an existing IRA or qualified retirement plan such as a 401(k), 403(b), 457(b), etc. This option would require the use of the Uniform Lifetime Table to determine life expectancy for calculating annual RMDs.
- Treat himself or herself as the beneficiary rather than treating the IRA as his or her own. This option would require the use of the Single Life Expectancy Table. This option is especially attractive for avoiding the early withdrawal penalty if the surviving spouse is under age 59½ and needs income.
- Treat himself or herself as the beneficiary rather than treating the IRA as his or her own, using the decedent’s age when calculating RMDs through the use of the Single Life Expectancy Table. This option is not as commonly used as it is only more favorable for the surviving spouse when they are at least 13 years older than the decedent.
- If the IRA owner dies before the required beginning date (RBD), the beneficiary can distribute the assets within five years of the owner’s death, or over the beneficiary’s single life expectancy. There is no RMD for the year of the IRA owner’s death.
- If the IRA owner dies on or after the RBD, the beneficiary can distribute the assets over the longer of the remaining life expectancy of the decedent or the life expectancy of the beneficiary. If the RMD was not completed in the year of the IRA owner’s death, the beneficiaries must complete the RMD by year-end.
- If there are multiple beneficiaries, the inherited IRA assets need to be separated by December 31 of the year following the year of death. If the inherited IRA assets aren’t separated by then, the RMD will be based on the life expectancy of the oldest beneficiary, rather than the life expectancy of each individual.
- If the beneficiary is a minor, a guardian must be appointed. This guardian is pre-selected by the IRA owner, or the minor’s parents can step in as guardians after the fact.
- Non-spouse inherited IRAs use the Single Life Expectancy Table to determine life expectancy for calculating annual RMDs. Use your age as of your birthday in the year distributions must begin.
The following scenarios demonstrate how stretch IRAs work in real life.
John, a widower, passes away at age 80 in 2015. John has $500,000 in IRA assets as of December 31, 2015, and had completed his RMD. He listed his son, Bob, turning age 58 in 2016, as the primary beneficiary on his retirement account. John did not list his granddaughter, Julie, turning age 25, or his one-year-old great grandson, Phillip, as beneficiaries.
- Bob, age 58, uses the divisor provided by the Table 1 – IRS Single Life Expectancy Table for beneficiaries, which is 27.0, indicating Bob has 27 years of remaining life expectancy. There, Bob would divide the $500,000 by 27.0 to come up with an RMD amount of $18,519 for the year.
- If Julie, age 25, had been listed as the primary beneficiary, the $500,000 would have been divided by 58.2, her remaining life expectancy, to come up with an RMD for the year of $8,591. By selecting his grandchild, Julie, instead of his son Bob, the RMD would have been reduced by 54% or $9,928, leaving almost $10,000 more in the account to grow for future distributions.
- If one-year-old Phillip had been selected as the primary beneficiary, the $500,000 IRA would have been divided by his 81.6 year remaining life expectancy to come up with an RMD for the year of $6,127. By selecting his great grandson, Phillip, instead of his son, Bob, the RMD would have been reduced by 67% or $12,392, leaving the IRA with an additional $12,392 to grow for future distributions. Because Phillip is a minor, a guardian would be named to maintain, and take distributions from, the account.
Jeanette passes away at age 72 in 2015 with $1,100,000 in IRA assets as of year-end, and had completed her RMD. She is survived by her husband, Bryan, who will turn age 75 in 2016, daughters Ellen and Jane, turning ages 51 and 49, and two grandchildren, Joseph and Mary, turning ages 24 and 20, respectively. She listed her husband as the primary, and Ellen and Julie as 50/50 contingent beneficiaries. Joseph and Mary were not listed as beneficiaries.
- As a spouse, Bryan, age 75, would have the choice of treating the account as his own, rolling it into a qualified retirement plan, or treating himself as a beneficiary of the IRA rather than its owner. Since Bryan and Jeanette were close in age, Bryan would choose to treat the IRA as his own as his RMD would be lower than if he treated the IRA as an inherited IRA. Based upon the Uniform Lifetime table, Bryan’s life expectancy (divisor) is 22.9, causing the RMD to be $48,035.
- Let’s say either Bryan disclaimed the IRA (refused the IRA assets, so it passes to the contingent beneficiaries), or Ellen and Jane were originally named primary beneficiaries (this would have required spousal notarized consent). The RMD would then be based on their individual life expectancies, assuming they separated the inherited IRAs ($550,000 each) by December 31 of the year following death. Ellen and Jane’s individual life expectancies would be 33.3 and 35.1, causing them to take $16,517 and $15,670, respectively. By designating her daughters as beneficiaries instead of Bryan, the RMD would be reduced by 33% or $15,848.
- If Joseph and Mary were instead listed as primary beneficiaries and did not separate the inherited IRAs ($550,000 each) in time, the life expectancy used to calculate the RMD would be based on Joseph’s age since he is the older beneficiary. Joseph’s life expectancy is 59.1 years, causing the RMD to be $9,306 or a total of $18,612. By designating her grandchildren instead of her daughters, the RMD would have been reduced by 42% or $13,575. In addition, the RMD is 61% or $29,423 less than the RMD if Bryan was listed as the primary beneficiary.
Stretch IRAs are a great way to extend your legacy, but there are also important considerations when thinking about this strategy. One should be aware that transfers to grandchildren or great grandchildren may be subject to generation skipping transfer tax (GSTT) if your estate is above $5,450,000 for 2016. Each spouse has an estate/lifetime gift and generation skipping transfer tax exemption of $5,450,000. So if you have an $8 million estate and your grandchildren receive $7 million of it, the first $5,450,000 is not subject to estate tax or GSTT. However the remaining $1,550,000 would owe $1,240,000 in taxes (40% estate tax + 40% GSTT). Some states also impose an estate tax and a generation skipping transfer tax, however in those circumstances GSTT usually applies to real (real estate) and tangible property (collectibles, cars, boats, paintings) and not intangible property like retirement accounts. In addition, there’s a risk the government will pass legislation to disallow stretch IRAs for non-spouse beneficiaries.
If you are interested in discussing whether this strategy makes sense for your family, we recommend you contact your advisor. Don’t have one? Give us a call.
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Geoff has always enjoyed talking with people about finance, learning about their investments, financial strategy, and business sense. His interest only deepened with time, and what began as a hobby has now become a life-long passion, with an unparalleled passion for continuing education that makes him an expert in many subjects from traditional taxes and investments to business succession planning and executive compensation negotiations.
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