Mr. Smith is retiring. During his working years, he and his wife were careful with their budget, and saved a significant amount of money towards retirement. In working on a retirement plan with his financial advisor, he realizes that between his pension and his 401(k) assets, he and his wife have more than enough money to live on during retirement. They considered what to do with the excess funds, and decided that they would like to see their children and grandchildren receive the benefit. Leaving them the excess money through a will or a trust would do the trick, but could be expensive to implement, and possibly incur huge tax consequences. A better solution might be to use a stretch IRA strategy.
A stretch IRA is not officially in the IRS code. It is a wealth transfer method that allows you to potentially “stretch” and even grow the IRA assets over several generations. The strategy involves adjusting beneficiary designations to minimize so-called required minimum distributions (RMDs) over a long period of time.
The stretch IRA is not for everyone. It is most useful for affluent retirees and those who want to leave a financial legacy for their heirs. It does not work well when distributions need to be higher than the required minimum. It also is not for the highly undisciplined, as there is no structure that prevents taking more than the required minimum.
The benefit of the stretch IRA is in taking the required minimum distribution and only the required minimum distribution. Leaving as much money in the IRA as possible allows the bulk of the assets to continue to grow tax-deferred. Assuming the growth rate is higher than the rate of withdrawal, the IRA balance can actually grow larger over time, perhaps even double, in spite of the withdrawals.
It is helpful to review how a traditional IRA normally works. Contributions and investment income grow tax deferred – meaning no taxes are paid until money is taken out of the account. Then it is taxed as ordinary income.
If you don’t need the money, you don’t take the money out, thereby avoiding the tax consequence of withdrawals. Unfortunately, you can’t do this forever. The IRS eventually gets tired of waiting for its due. It requires that you start taking annual required minimum distributions (RMDs) beginning the year you turn 70 ½. Normally, RMDs must be taken by December 31 of each year. However, the first distribution can be delayed until April 1 following the year the account owner turns 70 ½; this is called the required beginning date. Two RMDs are due the year of the required beginning date – one for the previous year (by April 1) and one for the current year (by December 31). As a point of reference, because there is no tax liability due on qualified withdrawals from a Roth, a Roth IRA is not subject to RMDs.
Failure to take the annual required minimum distribution on time is 50% of the amount the RMD should have been.
The formula for determining the amount of your required distribution involves dividing the prior year-end account balance by the life expectancy factor. The IRS provides charts as to the life expectancy factor (the divisor factor) that should be used, depending on age and status of the one taking the distribution. There are three different tables currently in use:
The divisor factor goes down at each year of age. Because you are dividing by a smaller and smaller number each year, the amount of the RMD goes up each year. Therefore the older you are, the higher the amount of the RMD. The amount of the required minimum distribution also rises as the account balance rises.
Therefore the key to stretching an IRA farther is to name younger beneficiaries. The younger the beneficiary, the higher the divisor. The higher the divisor, the lower the RMD. The lower the RMD, the better potential for tax-deferred growth.
Distribution Options for the Beneficiary
Choosing beneficiaries is an essential step for implementing a stretch strategy. Beneficiaries can be your spouse, non-spouse persons, an estate, a trust, or a charitable institution. There are a number of beneficiary distributions allowed by the IRS. Different options are allowed, depending on whether the account owner died before or after the required beginning date of his/her RMDs, and who or what the beneficiary is.
Spouse as Sole Beneficiary
If the account owner died before the required beginning date (meaning RMDs have not yet started), and the beneficiary is solely the spouse, the spouse can leave the account in the deceased owner’s name, treat as his/her own, or use the five-year rule.
If the spouse leaves the account in the deceased owner’s name, he/she must take RMDs no later than December 31 of the year the deceased owner would have turned 70 ½; or if the spouse was already 70 ½, by December 31 of the year following the year of death. The single life expectancy table is used for this calculation, which has a lower divisor per age, which results in comparatively higher RMDs. Leaving the account in the deceased owner’s name is the default option.
If the spouse is under 70 ½, and decides to treat the account as his/her own, they won’t have to take RMDs until he/she turns 70 ½. They are also allowed to use the joint life expectancy table, which has a higher divisor per age, and results in lower RMDs.
The third option is to use the five-year rule. Here the surviving spouse is allowed to do whatever he/she wants until December 31 of the fifth year after the account owner dies. He/she can take money out each year, or wait until the end to take out the whole shebang. The 50% annual non-withdrawal penalty does not apply in this case.
If the account owner died on or after the required beginning date (meaning RMDs have started), the surviving spouse has two options. He/she can leave the account in the deceased owner’s name or treat as his/her own. The five-year rule does not apply.
If the spouse leaves the account in the deceased owner’s name the same requirements apply as above.
If he/she treats the account as his/her own, he/she must take the RMD for that year, calculated as if the owner was still alive. If the spouse is over 70 ½, the next RMD is due by December 31 of year following the original account owner’s death. If the spouse is under 70 ½, the spouse is not required to take any more distributions until he/she reaches that age.
Non-Spouse Individuals or Spouse Not Sole Beneficiary
There are cases where the spouse is not the sole beneficiary, or only non-spouse beneficiaries are designated. Non-spouse beneficiaries can be any individual other than the spouse or a qualified trust. Regardless of whether the account owner died before, on or after the required beginning date, RMDs must start by December 31 of the year following the account owner’s death, and for each year thereafter.
If the account owner dies before the required beginning date, then distributions can be made based on the life expectancy of the oldest beneficiary (default); by creating separate accounts for each beneficiary, allowing them to take RMDs using their own life expectancy; or using the five-year rule.
In the case of multiple beneficiaries, if the account is not divided into separate accounts for each one, the age of the oldest beneficiary is used to determine the life expectancy factor. This means that a lower divisor will be used, resulting in a larger RMD. If separate accounts are created, then each account will use that beneficiary’s own life expectancy factor, lowering the RMD for the younger beneficiaries.
If the account owner dies after the required beginning date, the same options apply, except for the five-year rule. The RMD for the year of death must be satisfied if not already done for the original account holder. The following year, the RMDs are calculated based on the beneficiary life expectancy.
A non-individual beneficiary is an estate, charity or non-qualified trust; or there is no designated beneficiary. In this case, only the five-year rule applies if the account owner died before the required beginning date. If he/she died after the required beginning date, the RMD is calculated based on the single life expectancy of the owner in the first year and each year thereafter.
A Note about the Five-Year Rule
Don’t do it if at all possible. Not only do you lose out on the potential for long-term compounded growth, you’ll have a huge tax liability. The tax liability could be further exasperated if the amount of the withdrawal raises your tax bracket, since the withdrawals are treated as ordinary income.
Also, Don’t Get Caught
Plan custodians have some leeway as to what kind of distributions they allow, among the options the IRS allows. In short, they don’t have to offer you all of them; for example, some custodians only allow the five-year rule for everyone. If a custodian does not allow you to take distributions the way you want to, you should to switch to another custodian.
A Final Note
The stretch IRA, when used as designed is a useful tool for transferring wealth and providing long-term financial support in a tax efficient manner. It requires a high degree of trust that your beneficiaries will use it the way you intended. You will have no recourse from the grave if they don’t. However, if your real intention is to simply to leave a financial legacy for your heirs for whatever their needs and circumstances are, then implementing a stretch IRA gives them more options as to how they can use the money.
You can easily judge the character of a man by how he treats those that can do nothing for him. James D. Miles
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