A stretch IRA, also called a legacy IRA or multi-generational IRA, is an estate-planning strategy used with any type of individual retirement account—it’s not a unique type of IRA. Individuals can use this strategy to maximize what they leave to their heirs when they don’t need all of their IRA assets to fund their own retirement.

The account holder names a younger heir—typically a spouse, child or grandchild—as the beneficiary. That beneficiary then carefully follows IRS guidelines for taking required minimum distributions (RMDs) to maximize the account’s longevity, creating a tax-advantaged account whose investments compound to share wealth across generations. Depending on the beneficiary’s age and the account balance, stretching an IRA across multiple generations may be possible.

The Math: How a Stretch IRA Works

John, age 65, has a Roth IRA worth $1 million. Roth IRAs do not require account holders to take any distributions whatsoever during their lifetime. John has so much money in his 401(k) from work that he does not need to draw on his Roth IRA to enjoy a comfortable retirement.

John is widowed, so he names his son, John Jr., age 35, as the primary beneficiary for his Roth IRA and his grandson, John III, age 5, as his contingent beneficiary, just in case John Jr. predeceases him.

John has now completed the first two steps in the stretch IRA process: not using IRA money he doesn’t need and naming primary and contingent beneficiaries for his account.

Twenty years later, John passes away at age 85, at which point his Roth IRA balance has grown to $3.2 million by compounding at an average annual rate of 6 percent for those 20 years. John Jr., now 55, inherits the $3.2 million Roth IRA. While his father has set up the stretch IRA strategy, it’s up to John Jr. to make it work properly. Fortunately, his father shared his wishes with him, so John Jr. knows what to do next. He has to follow the IRS’s rules about deadlines, account titling and RMDs to avoid losing the stretch strategy.

When John dies and the account becomes John Jr.’s property, it becomes an inherited IRA. First, John Jr. has to make sure his new account is titled something like  “John Doe IRA (Deceased January 1, 2017) FBO John Doe Jr.” (FBO means “for the benefit of.”) The account must be titled this way because the IRS requires it of any inherited IRA. John Jr. also must ensure that he does a direct trustee-to-trustee transfer of his father’s IRA, not a rollover, which is not allowed for stretch IRAs. And he must do this before the end of the year following the year his father died—in this case, by December 31, 2018. If he doesn’t, he’ll have to follow the five-year rule instead and he won’t be able to use the stretch IRA strategy.

Stretching Out Inherited IRA Proceeds

There are three ways a non-spouse beneficiary can handle the proceeds of an inherited IRA. One is the life-expectancy method, and the stretch strategy described here is a strategic use of that method to make inherited IRA assets last as long as possible by taking RMDs. Another is the five-year rule, which requires the account’s new owner to distribute 100 percent of the balance by December 31 of the fifth year after the IRA owner’s death. The third is to take all the money at once.

Inherited IRAs have RMDs, even Roths, which don’t require RMDs while the original owner is alive. The good news: Since John Jr. has inherited a Roth that his father was contributing to for more than five years before his death, those RMDs will be tax-free income to him because his father already paid taxes on the contributions. When a non-spouse beneficiary like John Jr. inherits a Roth IRA, he calculates RMDs as if his father passed away before the required beginning date (RBD) for taking RMDs, even though there was no RBD.

So John Jr.’s next step in using the stretch IRA strategy is to take an RMD for the year his father died, 2017. This RMD can’t be included in the transfer to John Jr.’s inherited IRA, per IRS rules. Beneficiaries have to take RMDs of a certain percentage of the account balance based on their age and life expectancy using the IRS’s Uniform Lifetime Table III. John Jr. calculates the first RMD based on his father’s age of 85; his distribution divisor is 14.8, making his RMD $216,216 for 2017 ($3.2 million divided by 14.8).

Continuing Down the Stretch

In subsequent years, John Jr. will calculate RMDs based on a different distribution divisor, 28.7, based on his own age, 56. His 2018 RMD will be $110,654, which is calculated by dividing the account’s new balance, including any investment gain or loss, by 28.7. Using a stretch IRA calculator, John Jr. projects that the account balance will be exhausted after a distribution of $540,944 in 2046. He will have stretched his father’s Roth IRA assets out for nearly 30 years after his father’s death. John would be proud.

As the account’s new owner, John Jr. must be sure to name primary and contingent beneficiaries of his own. If he dies before the account balance is exhausted in 29 years, he wants his son to reap the same benefits he did. So he names John III, his son, as the primary beneficiary and his sister-in-law’s son as the contingent beneficiary. If John Jr. dies before the IRA is depleted, his son can repeat the same process to stretch the IRA even further.

If John Jr. needs more money than he’s required to take out in a particular year, he can increase his withdrawal above the required minimum. His account balance will run out faster as a consequence. It will also become less likely that the IRA will stretch to a third generation.

Stretch IRA Caveats

The stretch IRA strategy was made available in 2006 when a new law made it possible for nonspousal heirs to benefit from the deferred taxes associated with stretch IRAs. Now, Congress is interested in eliminating the stretch strategy to increase tax revenue.

A law proposed in September 2016 called the Retirement Enhancement and Savings Act of 2016 would eliminate the stretch IRA strategy if it passes (see Sec. 501. Modifications of Required Distribution Rules for Pension Plans). As the bill is worded now, it would only affect accounts with balances higher than $450,000—which might sound like a lot, but isn’t all that high for someone who contributes the maximum each year of his or her working life and invests in stocks (that investor could easily end up with $1 million by starting at age 22). If the stretch IRA is eliminated, beneficiaries will have to use the five-year method to draw down the amount in excess of $450,000. If that account is a Traditional IRA—and the beneficiary is in the peak earning years—the tax hit could be steep. It’s unclear when Congress will make a decision on this bill.

Speaking of tax hits, it’s easy to mess up this strategy and leave your beneficiary with a huge tax bill, which will be paid out of the IRA assets you wanted to leave to him or her. The biggest problem is not informing your heirs of the strategy you’ve planned for your assets. If they don’t know about the stretch IRA strategy or how to use it, they can’t execute your plan.

You’ll also need to make sure the firm that holds your IRA assets does stretch IRAs—just ask, and get the answer in writing. Also, the original account holder must be sure to name the account’s primary and contingent beneficiaries through the institution where the IRA is held—not merely in a will—to prevent it from being liquidated in estate settlement. Liquidation could result in an unwanted tax bill for your heirs.

The stretch IRA strategy is more effective with a Roth because it has no RMDs during the account holder’s lifetime, which helps to preserve the account balance for heirs, and because distributions are tax free, as long as they meet the five-year rule described above. A Traditional IRA does require RMDs during the account holder’s lifetime, starting at age 70½, and the account holder (and, later, the account’s beneficiary) must pay tax on the distributions.

To stretch an IRA as far as possible, name the youngest beneficiaries you can. The younger the heir is, the more time the account has to compound and grow because smaller distributions are required each year and it will take longer to deplete the account. It’s easy to change your beneficiaries at any time if you change your mind about what you want to do with your IRA assets.

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