The Individual Retirement Account (IRA) is a financial tool that allows individuals to save for their retirement in a tax-efficient manner. One of the types of IRA that has gained popularity over the years is the Stretch IRA. This type of IRA is not a specific type of retirement account, but rather a financial strategy that extends the tax-deferred status of an inherited IRA when it is passed to a non-spouse beneficiary.
It is called a “stretch” IRA because it stretches the tax-deferred benefits of the IRA over the lifetime of the beneficiary, rather than having the entire value of the IRA distributed shortly after the death of the original account holder. This strategy can provide significant tax benefits to the beneficiary, especially if they are younger and in a lower tax bracket.
Understanding the Stretch IRA
The Stretch IRA strategy is based on the concept of required minimum distributions (RMDs). The Internal Revenue Service (IRS) requires that, starting at age 72, IRA owners must begin taking RMDs from their accounts. These distributions are calculated based on the account holder’s life expectancy and the value of the account.
When the original IRA owner dies, the account can be passed to a designated beneficiary. If the beneficiary is a spouse, they can choose to treat the IRA as their own, or roll it into their own IRA. However, if the beneficiary is a non-spouse, they have a few different options. One of these options is to use the Stretch IRA strategy.
How the Stretch IRA Works
When a non-spouse beneficiary inherits an IRA, they can choose to take distributions over their own life expectancy. This is known as the “stretch” option. The IRS provides a table that outlines the life expectancy of beneficiaries based on their age. The younger the beneficiary, the longer their life expectancy, and the smaller the required minimum distribution.
By taking only the minimum required distribution each year, the beneficiary can stretch out the tax-deferred growth of the IRA for many years, or even decades. This can result in a significant amount of wealth being transferred to the next generation in a tax-efficient manner.
Benefits of the Stretch IRA
The main benefit of the Stretch IRA strategy is the potential for long-term, tax-deferred growth. By taking only the required minimum distribution each year, the remaining balance in the IRA continues to grow tax-deferred. This can result in a much larger balance over time than if the entire IRA were distributed shortly after the death of the original account holder.
Another benefit is that the distributions are generally taxed at the beneficiary’s income tax rate, which is often lower than the original account holder’s rate. This can result in significant tax savings for the beneficiary. Additionally, the Stretch IRA strategy can be a useful tool for estate planning, as it allows the original account holder to pass on wealth to their heirs in a tax-efficient manner.
Changes to the Stretch IRA
The Stretch IRA strategy was significantly impacted by the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was signed into law in December 2019. This legislation made several changes to the rules regarding inherited IRAs.
One of the most significant changes is that the Stretch IRA strategy is no longer available for most non-spouse beneficiaries. Under the new rules, most non-spouse beneficiaries are required to fully distribute the inherited IRA within 10 years of the original account holder’s death. This is known as the “10-year rule.”
Exceptions to the 10-Year Rule
There are a few exceptions to the 10-year rule. These exceptions allow certain beneficiaries to continue using the Stretch IRA strategy. The exceptions apply to beneficiaries who are:
- A surviving spouse
- A minor child of the original account holder (until they reach the age of majority)
- Disabled or chronically ill
- Not more than 10 years younger than the original account holder
For these beneficiaries, they can continue to take distributions over their life expectancy, as under the old rules. However, once the minor child reaches the age of majority, they become subject to the 10-year rule.
Impact of the SECURE Act on the Stretch IRA
The changes made by the SECURE Act have significantly impacted the use of the Stretch IRA strategy. For many non-spouse beneficiaries, the ability to stretch out the tax-deferred growth of the inherited IRA over their lifetime has been eliminated. Instead, they are now required to fully distribute the IRA within 10 years, which could result in a larger tax bill.
However, for those beneficiaries who qualify for an exception, the Stretch IRA strategy remains a valuable tool. It allows them to continue to take advantage of the tax-deferred growth of the IRA, potentially resulting in a larger inheritance.
Alternatives to the Stretch IRA
With the changes made by the SECURE Act, many individuals are looking for alternatives to the Stretch IRA strategy. There are a few different options that can provide similar benefits.
One option is to convert the IRA to a Roth IRA. While this would require paying taxes on the conversion, future distributions would be tax-free. Another option is to use a charitable remainder trust (CRT). This allows the IRA to be distributed over a set period of time, with the remaining balance going to a charity of the account holder’s choice.
Roth IRA Conversion
A Roth IRA conversion involves transferring funds from a traditional IRA to a Roth IRA. This requires paying income taxes on the amount converted. However, once the funds are in the Roth IRA, they can grow tax-free, and future distributions are also tax-free.
This can be a beneficial strategy for individuals who expect to be in a higher tax bracket in the future, or who want to leave a tax-free inheritance to their heirs. However, it’s important to note that the conversion can result in a significant tax bill in the year of the conversion.
Charitable Remainder Trust
A charitable remainder trust (CRT) is a type of trust that allows the account holder to receive income from the trust for a set period of time, with the remaining balance going to a charity of their choice. The income can be a fixed amount (annuity trust) or a percentage of the trust’s value (unitrust).
This can be a beneficial strategy for individuals who want to support a charity, while also receiving income during their lifetime. Additionally, the account holder can receive a charitable deduction for the value of the remainder interest that will eventually go to the charity.
Conclusion
The Stretch IRA was a valuable strategy for passing on wealth in a tax-efficient manner. However, the changes made by the SECURE Act have significantly limited its use. For most non-spouse beneficiaries, the ability to stretch out the tax-deferred growth of the inherited IRA over their lifetime has been eliminated.
However, there are still options available for individuals who want to pass on their IRA in a tax-efficient manner. Strategies such as a Roth IRA conversion or a charitable remainder trust can provide similar benefits. As always, it’s important to consult with a financial advisor or tax professional to determine the best strategy for your individual circumstances.
