Commentary by Joel Harris
One of the most powerful estate planning tools is the “stretch IRA,” which is a Traditional IRA or Roth IRA designed to allow an account owner’s beneficiaries the ability to continue tax-deferred or tax-free growth during one or more generations after the death of the original account holder.
Simply put, a stretch IRA can potentially have a profound effect for multiple family members if a huge wave of wealth is transferred during the coming years.
The first step in building a sound wealth transfer strategy is to determine to whom you’d like to leave your IRA assets. Your beneficiaries might include your spouse, children, grandchildren, a trust, a friend or neighbor, a charity or a combination of all of these.
It is imperative to do beneficiary reviews because your wishes might change.
If your spouse is designated as the beneficiary of your Traditional IRA, they have a unique advantage in that they may choose to roll the remaining account balance over to his or her own Traditional IRA.
This is powerful because the spouse has the ability to make additional contributions to the IRA, name his or her own beneficiaries; and most importantly, wait until he or she is 70½ before starting required minimum distributions. This allows a spouse the ability to take advantage of the tax-deferred growth and not immediately take distributions, which count as ordinary income.
On the other hand, a non-spouse beneficiary of a Traditional IRA must begin taking RMDs (required minimum distributions) by Dec. 31 of the year following the death of the original account owner. This is where the “stretch” features really come into play for a non-spouse beneficiary.
Instead of RMDs being calculated by the original account holder’s age, the RMDs will be based on the beneficiary’s life expectancy factor as defined by the IRS’s “single life expectancy” table.
Here’s a simple example to illustrate how the stretch IRA strategy works for a non-spouse beneficiary of a Traditional IRA.
Harry is age 79, and has a Traditional IRA worth $400,000. Since Harry is older than 70½, he’s required to take RMDs based on his life expectancy. Based on his age, he will be required to withdraw at least $20,512 ($400,000 divided by 19.5), and it will be taxed as ordinary income.
Then Harry dies and names Suzy, his daughter, the beneficiary of his Traditional IRA. Suzy opens an inherited IRA and transfers the assets into the account. Suzy is 47 years old when she inherits her father’s account. Instead of RMDs being calculated on Harry’s age, the new RMDs will be calculated based on Suzy’s age. Because Suzy must take an RMD by Dec. 31 of the year following her father’s death, she will need to start taking withdrawals at age 48. At age 48, the dividing factor in the single life table for inherited IRAs is 36, so Suzy’s RMD on a $400,000 inherited IRA is $11,111 the first year, which is far less than what her father would have been required to withdraw. It is important to note that this required distribution will be taxed as ordinary income for Suzy.
The RMDs will grow for Suzy every year, but as you can see, this strategy allows her to keep more money deferred from taxes, which can potentially have a profound effect on the compounding effect of her inheritance during her lifetime.
In this column, I only primarily focused on the inheritance of a Traditional IRA. If you’re the lucky beneficiary of a Roth IRA, some different rules apply.
A stretch IRA can be one of the most powerful estate tools to leave a lasting legacy for future generations. Secondly, they can lessen the effect of ordinary income tax liability for beneficiaries because they can stretch the required distributions over a longer period of time.
As 10,000 baby boomers turn 65 every day in this great country, educating yourself on the most efficient ways to preserve and transfer your hard earned money is vitally important.
Joel Harris, AAMS, is a financial advisor with Transamerica Financial Advisors. He can be reached at 573-2252 or via email at firstname.lastname@example.org.