Your smart and simple guide to Stretch IRAs

Up until 2020, a Stretch IRA was used as a method for inheritance planning through an IRA. Creating a setup for a Stretch IRA to occur, assets could grow tax deferred even when passed from generation to generation.

Read on to learn more about the Stretch IRA and how the passage of the SECURE ACT of 2019 affected it. Also see if the other alternatives to estate planning could be possible solutions in lieu of starting a Stretch IRA.

It is always important to speak with a tax or estate planning professional when it comes to making decisions for your, or your beneficiaries’, financial future. They can help you make educated decisions based on your future cash flow needs, lifestyle, tax savings and risk tolerance.

What is a Stretch IRA?

A Stretch IRA is not a separate account or vehicle in itself. It is the name given to an IRA that is passed down between generations with the intention to preserve the tax-deferred status of the assets in it.

Let’s first back up and define an IRA. An IRA is an individual retirement account, or IRA for short, that is set up with a bank, investment firm, mutual fund, insurance company or individual under the auspices of the IRS.

An IRA lets you contribute pre-tax dollars to an account every year up to a certain limit. The funds then grow within the account until retirement. A traditional IRA requires you to take distributions, called RMDs, from the account at age 70 ½ or 72, depending on your birth year.

And since the money has not been taxed, you have to pay taxes on the income you take as distributions from an IRA. So for instance, you will be taxed on your RMDs. Or if you have a Roth IRA, there are no RMDs required as the owner of the account.

A Stretch IRA comes into play when, at the passing of the IRA’s owner, it goes to a spouse who is 100% beneficiary of the account. In this setup, the spouse gets to take over ownership of the original IRA and the funds can continue to be tax deferred in the account. Then at the spouse’s passing, the IRA then continues to the next younger generation designated as a beneficiary.

In this way, a single IRA with all its tax-deferred benefits could be stretched from an owner to generations ahead.

How Stretch IRAs Worked

Now, creating a Stretch IRA took some planning, and a specific set up that allows for younger spouses and non-spouse beneficiaries to play a role. Here is how it worked for a Traditional IRA:

1. The owner opens a Traditional IRA and names their spouse as the single and sole beneficiary.
2. At the owner’s passing, the spouse takes ownership of the IRA and rolls it over into their IRA assets.
3. The spouse names a new younger beneficiary, such as a child for example, on the account.
4. When the spouse comes to the age of 70 ½ or 72, they can begin taking RMDs based on their life expectancy
5. At the passing of the spouse, the younger beneficiary or 2nd generation, is then able to take the IRA as an Inherited IRA.
6. The 2nd generation beneficiary is then able to take income as RMDs from the Inherited IRA based on their life expectancy

If the funds in the original IRA account are properly invested and contributions are made, the 2nd generation beneficiary can have a sizable income for life provided by the Stretch IRA.

Each time the IRA is passed on, the RMDs are recalculated based on the life expectancy of the new owner.

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Could you stretch a Roth IRA?

Yes, you could stretch a Roth IRA too. Similar to a Traditional IRA, you would need to name your spouse as the beneficiary so they can roll it into their own Roth IRA when the time comes. They would then need to name the younger or 2nd generation beneficiary on the account.

The difference is, that since it is a Roth IRA, you and your spouse will not need to ever take Required Minimum Distributions. Which actually allows for the funds to stay in the account longer and be stretched farther.

But, the 2nd generation beneficiary will need to take RMDs when they inherit the Roth IRA. These RMDs would be based on their life expectancy, and not you or your spouse’s. An additional benefit is that the distributions would also be tax free, as long as the account had been held for at least 5 years.

Benefits of a Stretch IRAs

The Stretch IRA was a way to use IRAs as an estate planning tool if you already had a sufficient amount of retirement savings and did not need to take these additional funds in the IRA.

So by allowing it to grow tax-deferred and with the intention of passing it on, the Traditional or Roth IRA is able to benefit your spouse and the next generation.

Even if it is not fully utilized by your spouse, the RMDs required per the life expectancy of the 2nd generation provides a cushion of income on top of extended growth. However, keep in mind that income taxes are to be paid on any distributions received since the contributions were tax deductible.

2020 changes to Stretch IRAs

The Stretch IRA came to a halt with the passing of the SECURE Act. The SECURE Act, an acronym for Setting Every Community Up for Retirement Enhancement, went into effect starting January 1, 2020.

The SECURE Act now made it required that the 2nd generation non-spousal beneficiaries must withdraw all the funds from the account within 10 years. Where previously the distributions for the 2nd generation could have lasted 50+ years, or however long, if the life expectancy was such.

There are tax implications on the 2nd generation beneficiary with the distributions during the new time frame of 10 years. By creating a time bound limit, this can coincide with a high tax rate due to the 2nd generation’s earning power at the age they inherited the IRA. And if the 2nd generation beneficiary doesn’t draw the full amount down in 10 years, there will be a tax implication on the entire amount in the Inherited IRA.

However, there are a few exceptions.

First, the SECURE Act’s new rule is only for those who inherit an IRA in 2020 or after. So if the Stretch IRA was already in place and existing prior to 2020, and the 2nd generation beneficiary already inherited it, there is a high likelihood that it can stay intact.

Second, there are specially Eligible Designated Beneficiaries, or EDBs, that are exempt from the new rule. They include:

• Spouses
• Beneficiaries who are children and currently considered minors. The 10 year rule does kick in when they reach the age of 26 or when they are no longer a minor
• Beneficiaries with disabilities, or who are chronically ill
• Non-spouses who are within 10 years of the owner’s age, like a brother or sister or cousin

Alternatives to a Stretch IRA

The intention behind a Stretch IRA is to leave accumulated wealth to the next generation and provide tax deferred growth as well. So although the Stretch IRA, in essence, is being done away with, there are other options to consider for your estate planning.

Speak to your retirement and estate planning professional to see if any of these following options could work for you.

• Roth IRA: if you suspect tax rates will be going up or that your beneficiaries may have a high tax rate, you can take a look at Roth IRAs. Roth IRAs provide the benefit of tax free withdrawals from the account when taken as distributions. Going the Backdoor Roth IRA route can help individuals who don’t meet the eligibility criteria for a Roth IRA.

• Qualified Charitable Donations from an IRA: This allows for direct transfers from your IRA to a charity. This type of charitable donation from an IRA is not seen as income to you as the IRA owner, so it would not have an implication on your current taxes. And the withdrawal can satisfy your RMDs for the year.

• Life Insurance: You can use Traditional IRA withdrawals to purchase life insurance that would benefit the next generation. The life insurance allows for a tax-free death benefit for the beneficiaries. But this may only be a feasible or effective strategy if you are above 59 ½ years old.