Stretch IRAs

Stretch IRAs

In reality, the stretch IRA was not a type of IRA. Rather, it was a method of wealth transfer involving an IRA — specifically, any non-spousal beneficiary you have designated to inherit your IRA. With this strategy of estate planning, you've had the potential over several generations to "stretch" the distributions (and tax benefits) of your IRA.

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The ability to have and use a stretch of IRA ended with the signing of the spending bills which included the Setting Every Community Up for Retirement Enhancement Act, better known as the SECURE Act, on Dec. 20, 2019.

How Does a Stretch IRA Work?

Most IRA owners typically refer to their spouse as the primary beneficiary of the IRA and their children as the contingent beneficiaries.

While this strategy has nothing wrong with it, it may require the spouse to take more money from the IRA than they really need — and pay taxes on it, too.

You once had the option of missing a generation (or two) and naming grandchildren or great-grandchildren as IRA beneficiaries, assuming that your spouse and children did not need that extra income.

That tactic spared older family members from receiving the IRA from the tax burden.

Every year, the grandchildren (or whatever non-spouse recipient you designate) still had to take RMDs from the account. But the amount could be figured on their age—not that of the original account holders.

Since grandchildren are younger, the amount they would have had to withdraw would be significantly smaller than the spouse or children would have had to take.

The fact that RMDs were based on IRS life-expectancy tables was at the core of the stretch IRA strategy.

The longer you lived, the smaller the annual withdrawal.

In effect, young beneficiaries were allowed to stretch the IRA’s value over a longer period, reduce the amount of the taxable withdrawal, and allow the IRA assets to accumulate tax-free for more years — even decades.

Alternatives To Stretch IRAs

1. Convert to a Roth IRA

Investors now willing to pay taxes should consider converting a traditional IRA into a Roth IRA. Ideally, any taxes paid would be at a lower rate than future beneficiaries would pay.

Moreover, those tax payments to Uncle Sam would help reduce their estate, which could be ideal for wealthy investors concerned with the federal estate-tax exemption returning to $5 million (inflation-adjusted) in 2026, from the $11.58 million per individual it is now.

Of course, the Roth IRA would still be part of the estate, and most non-spousal beneficiaries will still have to deplete the IRA within 10 years.

However, each beneficiary will receive Roth IRA distributions tax-free.

2. Charitable Remainder Trust

After the death of the IRA owner, the IRA funds would be paid following the trust agreement to the trust and then to the beneficiaries of the trust (such as children or grandchildren).

This approach takes place around the 10-year rule and allows the IRA owner to dictate the distribution term.

This approach can also satisfy charitable goals, though setting up the trust and the ongoing administration can be pricey. Also, upon receiving distributions, beneficiaries could have to pay taxes.

There is no way around charitable function; there must be a certain percentage left to charity.

3. Purchase life insurance

This could be a feasible option for someone between the ages of 591⁄2 and 72 when minimum distributions are not mandatory and penalties for early distribution are not a problem.

With this strategy, IRA owners could use distributions to buy cash-value life insurance, naming as beneficiary a child, grandchild, or trust.

They would pay income tax on the IRA distributions that were used to fund the policy, but by doing so they would also reduce their estate size.

The funds in the policy would grow tax-free afterward. The funds are generally allocated in a lump sum once the owner dies, although there may be other options if the beneficiary is a trust.

There are good news and bad news for retirement savers whose stretch-IRA strategies have been updated by the Secure Act: workarounds exist, but none of them necessarily provide a perfect replacement for the popular property planning tool. There are still moves IRA owners can make to help facilitate the transfer of their legacy to their chosen beneficiaries and save taxpayers some money.

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