Have you ever heard the term “stretch IRA”? According to the IRS, there is no such thing. What has become known as a stretch IRA is really a withdrawal strategy geared to spread the tax-deferred status of your IRA assets across multiple generations. Basically this is a provision you can add to any traditional IRA, ROTH, SEP-IRA, or SIMPLE IRA by using a beneficiary designation form.

Typically, a spouse is named as the primary beneficiary of an IRA, with children as the contingent beneficiaries. In this approach, after your death your surviving spouse rolls the balance of your IRA into his or her own IRA. This will allow your spouse to use the money from your IRA to cover his or her living expenses.

Alternatively, if your spouse will not need the assets in your IRA for living expenses in retirement, then you may consider naming your children and/or grandchildren as the primary beneficiaries. This will create the “stretch IRA.” After your death, your beneficiaries would each acquire what’s known as an inherited IRA from which he or she would have to withdraw a required minimum distribution each year thereafter. Here is an example to illustrate:

John (original IRA owner) passes away in December of 2011. His IRA has a balance of $600,000 on 12/31/2011. Below are the hypothetical required minimum distributions depending upon who inherits John’s IRA:

  1. Spouse: Susan (age 75 in 2012); her RMD will be $26,200.87 in 2012.
  2. Son:  Mike (age 50 in 2012); his RMD will be $17,543.86 in 2012.
  3. Grandson:  Evan (age 25 in 2012); his RMD will be $10,309.28 in 2012.

For John’s son and grandson the RMDs would be significantly smaller, based on a separate IRS table for non-spouse beneficiaries. If they withdrew only the required minimum amounts, the assets in their inherited IRAs could continue to grow on a tax-deferred basis and could potentially last the rest of their lifetimes. This is effectually like creating a personal pension for your child or grandchild.

How should I invest my IRA if I don’t need the money?

One approach you may consider is to invest the IRA using the risk tolerance of your children if the money will ultimately pass to them. Your advisor can help you explore the implications of this choice.

Can I establish an inherited IRA now?

Unfortunately, no.  An inherited IRA is created only after the original IRA owner has died. If you are interested in the stretch IRA strategy, you may consider including your named beneficiaries (children and/or grandchildren) in your planning discussions and educate them on this plan and your wishes.

How are inherited IRA distributions taxed?

Generally, RMD distributions are taxable to the recipient as ordinary income with the exception of an inherited ROTH. The more they take out each year, the greater the taxes they will likely owe. Owners of inherited IRAs are not subject to 10% early-withdrawal penalties on RMD distributions.

Are there any drawbacks with an inherited IRA?

Tax laws can change at any time, and what is true today might not be true next year.

The stretch IRA is only an opportunity to extend the life of an asset, but it’s no guarantee of how the new owner will use that. Your heirs may take out more than their RMDs, subject of course to taxes, or may liquidate the entire account. You may consider this an education opportunity for your children and your advisor can help with this.

Still, if it is used properly, the stretch IRA approach is a relatively straightforward way to provide an added income stream for your children or grandchildren throughout their lives. If you are interested, please consult with your financial or tax advisor.