Stretch Out Your IRA

January 8, 2009
Special Feature

How would you like to make your grandchildren rich? Would it put a smile on your face to ensure that your great-grandchildren never have to worry about money? It’s easier than you might think if you have an Individual Retirement Account.

How would you like to make your grandchildren rich? Would it put a smile on your face to ensure that your great-grandchildren never have to worry about money? It’s easier than you might think if you have an Individual Retirement Account.

Individual Retirement Accounts (IRAs) have been one of the most popular retirement vehicles for the past generation of investors. In fact, according to the Investment Company Institute, Americans have saved over $4.6 trillion for retirement using IRAs and another $3 trillion through employer-sponsored 401(k) plans.

One of the primary benefits of IRAs is that they allow your investments to grow, tax-deferred, until withdrawn, typically at retirement. The stretch IRA takes this concept a step further, allowing you to pass the tax deferral benefits of your IRA to your heirs—possibly even over several generations.

The concept of a stretch IRA is a bit complicated, but at its heart is the miracle of compounding. By designating a grandchild or great-grandchild as the beneficiary of your IRA, you allow them to extend the effectiveness of the IRA over their lifetimes. The further down the family tree you pass the IRA, the greater the potential benefits.

How a stretch IRA usually works

To understand the benefits of a stretch IRA, you must first understand what happens if you die without naming a designated beneficiary for your IRA account. As with many things involving the IRS, the default rules are both complex and draconian.

If you die before your Required Beginning Date (RBD)—generally April 1st of the year after you turn 70½—your beneficiaries must withdraw all of the funds in your IRA under what is known as the “5 year rule.” This means that the entire balance of the IRA must be distributed by the end of the 5th year following your death, and the IRA’s tax deferral benefits are lost forever.

If you are lucky enough to die on or after your RBD, then your heirs can extend the payout schedule over your remaining statistical life expectancy based on the IRS Single Life Table. Depending on how old you are when you die, this might give your heirs a few extra years of tax-deferred compounding before they must drain the account dry.

Beauty of stretching it out

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Here’s where things get interesting. If you identify a designated beneficiary for your IRA, that person will then be able to take out the funds over own statistical life expectancy—not yours. The younger your designated beneficiary, the longer their life expectancy and the more tax-deferred growth they will be able to generate in the IRA.

For example, let’s say you die at age 75 with $100,000 left in your IRA, and you leave it to your 50-year old daughter. Based on the IRS tables, she can take distributions over her life expectancy of 34.2 more years. In contrast, had you designated your 10-year-old grandson as your beneficiary, he could take the money over his life expectancy of 72.8 more years. That’s almost 39 more years of tax deferred growth—or an additional $870,000 (assuming an annualized 6 percent return).

Possible pitfalls

As I mentioned at the outset, the rules governing IRAs are extremely complex, and there are many pitfalls facing anyone seeking to implement a stretch IRA strategy. In particular, keep in mind:

  • You must designate a beneficiary for your IRA using an IRA beneficiary designation form. It is not enough to name someone in your will or other estate planning document. Remember, no designated beneficiary means no stretch IRA.

  • Not all financial institutions will let you stretch your IRA. Before you open an account, check with your custodian or broker to make sure they will allow it.

  • Be careful: leaving large IRA accounts to grandchildren and great-grandchildren may trigger the IRS’s generation-skipping transfer tax provisions.

David A. Twibell, J.D., is President of Wealth Management for Colorado Capital Bank, where he directs the bank’s portfolio management and wealth advisory practice.He can be reached at (303) 814-5545 or dtwibell@coloradocapitalbank.com.