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What Is a Stretch IRA?
Finding a method to leave a lasting legacy to your loved ones
without increasing their tax burdens can be difficult and complicated. A
“stretch” IRA may be a useful approach that can benefit your heirs for
generations to come.
A stretch IRA is not a special type of IRA but rather a term
frequently used to describe this IRA strategy, also known as a
“multigenerational” IRA, that can be used to extend the tax-deferred savings
on inherited IRA assets for one or more generations to benefit future
beneficiaries.
Here’s how it works. You let the funds accumulate in the IRA
as long as possible. You name as beneficiary someone younger, perhaps a son
or daughter. When you have to start taking required minimum distributions (RMDs)
from your traditional IRA after turning age 70½, you take only the
minimum annual amount required by the IRS each year. (If you fail to
take a minimum distribution, you could be subject to a 50% income tax
penalty on the amount that should have been withdrawn.)
When your beneficiary inherits your IRA, he or she might also
have the ability to take required minimum distributions (RMDs) based on his
or her life expectancy. (RMDs are calculated each year and must begin no
later than December 31 of the year following your death.) In this way, your
beneficiary would have the potential to stretch the distributions over his
or her own lifetime, which enables the funds to continue compounding tax
deferred for a longer period and avoids a large initial tax bill. Your
beneficiary can also name a beneficiary, who can potentially stretch the
distributions even longer.
There is a limit to how long you can “stretch” an IRA. The
IRS doesn’t want to postpone taxes indefinitely. The distribution period
cannot extend beyond the first-generation beneficiary’s life expectancy. For
example, if you designated your son to be the sole beneficiary of your IRA
and he was 40 when you died (and you hadn’t yet reached the age for taking
RMDs), he could take RMDs based on his 42.7-year life expectancy, starting
the year after you died. If he died 20 years later, his designated
beneficiary could continue taking minimum distributions based on what would
have been your son’s remaining life expectancy (22.7 years).
Of course, nonspouse beneficiaries of IRAs face some hurdles.
There are different sets of rules to determine the RMDs that a non-spouse
beneficiary must receive. They depend on whether the original account owner
died before, on, or after reaching the required beginning date for RMDs. Not
only are these rules complex, but they can have far-reaching implications.
Spousal beneficiaries of IRAs have more options than non-spouse
beneficiaries.
If you have a desire to extend your financial legacy over
future generations and don’t need the IRA assets for income during your
lifetime, then this strategy may be appropriate for you. Because many tax
and distribution rules must be followed, make sure to seek legal or tax
counsel before making any final decisions.
Note: Make sure the provisions in your IRA allow
beneficiaries to take distributions over their lifetimes and to name
second-generation beneficiaries. Distributions from traditional IRAs are
taxed as ordinary income. Distributions prior to age 59½ are subject to a
10% federal income tax penalty (this rule does not apply to IRA
beneficiaries, who must begin taking minimum distributions no later than
December 31 of the year following the original owner’s death). Beneficiaries
also have the flexibility to take out more than the minimum distribution at
any time.
© 2007 Emerald Publications
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