Updated May, 2018 to include changes resulting from the Tax Cuts and Jobs Act
What if you could delay the income tax consequences of your death for your beneficiaries?
A tax deferral can provide a sizeable financial benefit for your loved ones — and with a little advance planning, you can do just that. The method is known as a stretch-out IRA.
With traditional IRAs, your beneficiaries pay income taxes on the retirement assets they inherit after your death but only when the assets are withdrawn from the IRA account. Until withdrawn, the IRA assets grow tax-free.
Stretch-out IRAs are designed to allow your beneficiaries to defer the income taxes on retirement assets for very long periods. The assets continue to grow tax free for decades, and possibly for generations.
The Stretch-out IRA Option
A stretch-out IRA is an IRA with a very young designated beneficiary. The use of a young beneficiary allows for a long withdrawal period after the death of the IRA owner and is perfectly allowable under the IRS’ IRA withdrawal rules.
The benefits of the inherited IRA accrue to your beneficiaries. They include ongoing tax-deferred growth for your retirement account assets after your death and lower minimum distribution requirements. Your beneficiaries will have to take a small taxable distribution each year, based on their life expectancies, but the bulk of the money grows without current tax consequences.
To illustrate the magnitude of the stretch-out IRA option, assume a daughter inherits her father’s $1 million IRA account upon his death as his designated beneficiary. She is 40 years old at the time.
Under the conventional IRA withdrawal option, where the beneficiary withdraws the $1 million immediately, the daughter nets about $676,000 after taxes or withdraws it over 5 years and she nets about $926,000 (assuming six percent earnings over the five years).
Under the stretch-out IRA option, the IRS will allow the daughter to take distributions over more than four decades. If she earns six percent on the funds, her minimum distributions over that time period will exceed $3.89 million.
But what if the 10 year old granddaughter were named beneficiary? She could potentially withdraw the IRA over more than 70 years. With six percent earnings, her minimum distributions would be more than $14.8 million.
The stretch-out IRA works best if there is no estate tax on the IRA or if the estate has other funds to pay any estate tax on the IRA. It is also important to make sure that there are no adverse consequences to the IRA owner’s surviving spouse. Ideally, the stretch-out IRA planning is done with the intention that it will take effect after the death of the surviving spouse.
Establishing a Stretch-out IRA
A stretch-out IRA can be either a traditional or a Roth IRA. However, not all IRA custodians offer a stretch-out IRA option. It is important to confirm (preferably in writing) that your bank or other financial institution will allow your beneficiaries to withdraw the assets according to their life expectancies rather than mandating an immediate withdrawal. If the answer is no, you should consider a change in custodians.
The choices you make to establish your stretch-out IRA — including the primary and contingent beneficiaries you choose — and the tax considerations involved require careful consideration and a knowledge of applicable IRS regulations. A wrong choice can have significant financial and tax consequences. It’s wise to consult an expert who can help you maximize benefits and avoid potential pitfalls.
Once you’ve established your stretch-out IRA and selected primary and contingent beneficiaries, it is important that the beneficiaries are educated regarding the basic workings of the stretch-out IRA. They should understand the options available to them upon your death, so that they act in a way to preserve the financial and tax benefits you have created.
Selecting the Appropriate Beneficiaries
As the owner of an IRA, you can name one or more of the following as your beneficiaries:
a person other than a spouse
a nonhuman entity, such as an estate, trust or charitable organization
If you choose the latter, you should know that most nonhuman beneficiaries do not have the option of stretching out the IRA.
In addition to your primary beneficiary or beneficiaries, you can also name one or more contingent beneficiaries. In the event that a primary beneficiary dies before the owner — or chooses to disclaim all or a part of the inherited IRA — the IRA account transfers to the contingent beneficiary.
In selecting beneficiaries, it’s important to factor in the potential impact of the kiddie tax for child and grandchild beneficiaries. Under the Tax Cuts and Jobs Act, children age 18 or younger — and full-time students age 23 and younger — are now taxed at trust tax rates for their unearned income, which includes IRA distributions. This typically results in a higher tax on IRA distributions which can reduce the benefits of adopting a stretch-out IRA.
If you’re bequeathing a Roth IRA, the distributions are not subject to tax so the kiddie tax doesn’t apply.
Minimum Required Distributions
Your beneficiaries will be required to take minimum required distributions based on life expectancy tables. If you have established more than one beneficiary, the beneficiaries can elect to separate their assets into multiple inherited IRA accounts by December 31 of the year following your death. If they do not do so, all distributions are based on the life expectancy of the oldest beneficiary.
Income Tax Consequences to Beneficiaries
All beneficiaries are subject to income tax based on the distributions they receive from the IRA. If you had a basis in your traditional IRA as a result of nondeductible contributions, that basis carries over to your beneficiaries.
Federal Estate Tax Consequences to Beneficiaries
In general, there is no estate tax deferral as a result of the stretch-out IRA. Your retirement assets are subject to estate tax. However, your beneficiaries can take a deduction for a portion of the federal estate taxes that are considered paid on the IRA account.