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"Stretching" an Inherited IRA offers your heirs the potential for decades of tax-advantaged growth.
Individual retirement accounts (IRAs) have earned a reputation as an effective retirement planning and savings tool. But they have another valuable use that’s less widely known: as a tool to transfer wealth. Retirees can use a stretch IRA strategy to pass on wealth to others, including their children or grandchildren, generally by designating them as beneficiaries of an IRA. An "Inherited IRA" can provide heirs with decades’ worth of potential tax-deferred growth of their inherited assets. And while the account mandates minimum annual distributions, heirs can always withdraw more than the minimum if they need additional income. "Stretch IRAs are an effective way to extend the benefits of tax-deferred growth potential into the next generation and to provide heirs with an annual stream of supplementary income," says Christine Fahlund, CFP®, a senior financial planner with T. Rowe Price.
How to stretch an IRA
Married individuals often name their spouse as a beneficiary of their IRA, but in some situations the IRA owner may choose to extend the account’s life by naming younger heirs, such as children or grandchildren, as beneficiaries. When a non-spouse heir inherits the assets remaining in an IRA, he or she can take the balance as a lump-sum distribution—potentially triggering a large tax bill—or use the balance to fund an Inherited IRA. This second option is known as "stretching" an IRA, since the heir’s withdrawals can be extended over many years.
When an IRA is stretched, assets in the account can continue to grow tax-deferred even as the balance is gradually drawn down through required minimum distributions (RMDs). The strategy works for both Traditional and Roth IRAs and can add decades of tax-advantaged growth potential. Distributions from an inherited Traditional IRA remain taxable as regular income. By contrast, the RMDs from a stretched Roth IRA are potentially 100% tax-free.
Choose beneficiaries carefully
Maximizing the benefits of a stretch IRA strategy starts with selecting beneficiaries. In general, the ideal candidates, assuming there is no surviving spouse, are children and grandchildren who have many years of life ahead of them. You may want to consider naming more than one beneficiary, or naming a spouse as a primary beneficiary and younger heirs as secondary beneficiaries.
Not all heirs will benefit equally, however. Younger heirs have longer to benefit from the tax-deferred growth potential of an Inherited IRA. Moreover, annual RMDs are based on the life expectancy of an account’s oldest beneficiary. All else being equal, you may want to consider separating a single IRA into separate accounts now, one for each beneficiary, so the younger beneficiaries benefit from smaller annual RMDs. (See Youth Benefits From a Stretch to see the real difference age makes when choosing a beneficiary.) Otherwise, the same account separation can occur after the assets are inherited by the beneficiaries, provided certain deadlines are met.
If your heir does not deplete the funds in the Inherited IRA during his or her lifetime, he or she can pass down the account to his or her own heirs. The RMDs for this next generation of heirs are calculated slightly differently, however: They are based on the life expectancy of the first-generation heir. Say you leave an IRA to your daughter, who stretches the IRA and names her son as beneficiary. When the son inherits the account, his required withdrawals will be based on his mother’s life expectancy were she still alive, not his own.
Special options for spouses
Surviving spouses typically roll over IRA assets they’ve inherited from a husband or wife into an IRA in their own name, explains Fahlund. In the case of the surviving spouse rolling over the assets to a Traditional IRA, tax-deductible contributions and earnings are subject to a 10% penalty if withdrawn before age 59½, and RMDs must start at age 70½. The surviving spouse can name his or her own beneficiaries, who will have the option to "stretch" their inherited assets someday.
YOUTH BENEFITS FROM A STRETCH
Younger owners of Inherited IRAs have longer life expectancies, resulting in smaller RMDs than older owners and more years to benefit from tax-advantaged growth potential.
Assumes a 7% annual average rate of return and an Inherited IRA balance of $100,000.
*Approximate life expectancy of 83, with 65 years (83-18) remaining.
**Approximate life expectancy of 84.6, with 29.6 years (84.6-55) remaining.
While most surviving spouses can roll inherited IRA assets into their own existing IRAs, non-spouse beneficiaries cannot. They must keep their Inherited IRAs separate. Inherited IRAs require RMDs starting in the year following the owner’s death, and beneficiaries may draw on the accounts at any time without triggering early withdrawal penalties. For this reason, an Inherited IRA also may be a wise choice for spouses who are much younger than their deceased husband or wife. In this case, RMDs and any other withdrawals from an inherited account before the beneficiary is age 59½ are not subject to a 10% early withdrawal penalty.
To achieve the full benefit of a stretch IRA strategy, you need to plan properly. Educate your beneficiaries now about the choices they’ll face in the future, as well as the opportunities that may arise from stretching an Inherited IRA. "Otherwise, your heirs might take a lump-sum distribution of their inheritance without realizing the benefits of the stretched tax-deferral," says Fahlund. Once you’ve made a plan and shared it with your heirs, you can be secure in the knowledge that you have provided them an effective, versatile opportunity to make the most of their inheritance.