If you’re taking time to improve your financial literacy this month, you might have come across some terms and concepts that are unfamiliar to you. This is often the case when it comes to retirement and estate planning topics. One unfamiliar area might be the concept of a stretch IRA. This topic came up a lot earlier this year following President Obama’s 2016 budget proposals, which would eliminate stretch IRAs. But what exactly is a stretch IRA in the first place?
Jeffrey Verdon, an attorney specializing in taxation and estate planning, took some time to chat with The Cheat Sheet and tell us a bit more. Verdon started by explaining that a stretch IRA is often used as an estate planning tool. This vehicle can be used to transfer assets on to heirs. Read on for more insight.
The Cheat Sheet: What is a stretch IRA?
Jeffrey Verdon: A stretch IRA is not a type of IRA but rather a strategy to extend the life of an IRA for successor beneficiaries. This concept allows the IRA investments to continue to grow tax deferred even after the death of the original account owner. This is a way for a taxpayer to leave his or her IRA to younger generation beneficiaries and defer the taxation of the untaxed profits inside the IRA as long as possible.
The rules (called the Required Minimum Distribution or RMD) allow the extended beneficiaries to begin to withdraw benefits from the IRA at age 59 1/2, but deferral may not continue past age 70 1/2, at which time the beneficiary must begin withdrawing the RMD. The stretch technique is designed to maintain the tax-free growth inside the IRA as long as possible.
CS: How long has the concept of the stretch IRA been around?
JV: The IRA was enacted into law in 1974 and the loophole has been around since the law was enacted, but look for Congress to close this loophole by allowing the stretch period to last for a defined period of time.
CS: How does a stretch IRA work?
JV: Make sure you have designated primary and secondary beneficiaries for your IRAs. Limit your withdrawals to the RMDs to maximize the amount left to beneficiaries. When the IRA owner dies, beneficiaries may request to take RMDs based on their remaining life expectancy. Assuming the beneficiary is younger than the deceased IRA account owner, this often results in smaller amounts for the RMDs to the younger beneficiary and a longer tax deferral period.
CS: What are some consequences beneficiaries face if they withdraw from the account before five years after the IRA owner dies?
JV: The withdrawals will be subject to current income taxation when withdrawn.
CS: Which consumers do and don’t benefit from the stretch IRA technique?
JV: The taxpayers who do not need to withdraw money from the inherited IRA may elect to retain the investments in their inherited IRA as long as possible before having to commence the withdrawals. The consumer who needs to withdraw funds from the IRA will not enjoy the longer tax deferral period.