Stretch IRAs

These tools offer your clients powerful planning techniques.

By Gregory B. Gagne, ChFC, Aug. 2005

The single largest asset for many retirees other than their primary residence is their IRA. But most are completely unaware of the tax nightmare that awaits the beneficiaries of these accounts if the account holders have not properly established a plan to pass this tax-deferred asset to their spouses and children.

In 2001, the IRS overhauled the rules pertaining to mandatory distributions from IRAs; as a result, some excellent planning opportunities are available for the informed advisor. Today, with proper planning, your clients’ IRAs can live on for their families long after they are gone.

After an IRA owner’s death, a spouse can roll the IRA into his name. This spousal rollover is not a change in the rulings, but what can happen next is!

If the surviving spouse names a designated beneficiary of the IRA, the beneficiary can withdraw the funds from the IRA over his life expectancy after the parent dies. The planning potential of this technique is tremendous. Under the old rules, the beneficiary would simply cash out the parent’s IRA and pay the income taxes on the distribution, resulting in massive taxes for most beneficiaries.

Your clients’ IRAs can live on for their families long after they are gone.

With the new rules, the beneficiaries have a planning opportunity to take simply the required minimum distribution (RMD) based on their life expectancy, and the remaining account balance can continue to grow on a tax-deferred basis. The beneficiary can elect to remove more than the required distribution at any time if he needs additional funds.

The planning opportunity
Mr. John Smith, age 65, has an IRA valued at $100,000. Let’s assume that he earns 6 percent on this IRA and will be taking only his RMDs once he is age 70½. Assume he has one child whom he names the beneficiary of his IRA. His child (Bill) is age 40. Mr. Smith’s required distribution schedule will look like this:

Mr. John Smith’s IRA
Assuming 6% Return on Investment and Taking Only RMDs
Year	Age	Required Distribution	Account Value 12/31
2005	65	$ 0	$106,000
2006	66	0	112,360
2007	67	0	119,102
2008	68	0	126,248
2009	69	0	133,823
2010	70	4,884	136,968
2011	71	5,169	140,017
2012	72	5,469	142,949
2013	73	5,787	145,738
2014	74	6,123	148,359
2015	75	6,479	150,782
2016	76	6,854	152,976
2017	77	7,216	154,938
2018	78	7,632	156,602
2019	79	8,031	157,967
2020	80	8,447	158,998
2021	81	8,883	159,655
2022	82	9,337	159,898
2023	83	9,810	159,682
2024	84	10,302	158,961
2025	85	10,741	157,758

 

Now let’s assume Mr. Smith lives until age 85. When he dies, his son will be 61. His son has two choices. First, he can simply cash out his dad’s IRA (no stretch) and pay the income taxes due.

With no stretch planning, Bill will inherit $116,528, but with the stretch IRA planning, he will inherit $306,912. (The calculation assumes son is married, is filing a joint return and has taxable income of $50,000, excluding the required distributions.)

Bill must begin taking required distributions from his father’s IRA based on his own life expectancy starting the year following his father’s death. His father’s IRA is now worth $160,758, and his son, now age 61, must take a minimum distribution of $6,465.

Lump Sum Account Liquidation in 2026
Total distributions	$157,758
Federal income tax on total distribution	$41,230
Net after-tax to Bill	$116,528
Over 26 percent lost to taxes

Or he can stretch the IRA.

Required Distributions From 2026 Through 2050
Total distributions	$367,647
Federal income taxes	$ 60,735
Net after-tax income	$306,912
Only 16.5 percent lost to taxes

Bill must be listed as a designated beneficiary on the IRA beneficiary-election form for the stretch option to be valid. The easiest way to understand a designated beneficiary is that he is a beneficiary with a birth date. When the son notifies the custodian of the death of his father, he will most likely need to furnish a certified death certificate and also establish a beneficiary IRA with the custodian. At that time, the IRA provider will move the assets from the decedent’s IRA into the “inherited” IRA account. Keep in mind the account will stay in the name of the deceased for the beneficiary’s benefit but does not roll over into the son’s IRAs.

Mr. Bill Smith’s Inherited IRA
Assuming 6% Return on Investment and Taking Only RMDs
Year	Age	Required Distribution	Account Value 12/31
2026	61	$ 6,465	$160,758
2027	61	6,870	163,534
2028	63	7,301	166,045
2029	64	7,759	168,249
2030	65	8,247	170,096
2031	66	8,768	171,534
2032	67	9,322	172,503
2033	68	9,914	172,940
2034	69	10,545	172,771
2035	70	11,219	171,918
2036	71	11,939	170,295
2037	72	12,709	167,804
2038	73	13,533	164,339
2039	74	14,416	159,784
2040	75	15,364	154,007
2041	76	16,384	146,864
2042	77	17,484	138,192
2043	78	18,675	127,809
2044	79	19,970	115,507
2045	80	21,390	101,047
2046	81	22,965	84,145
2047	82	24,749	64,445
2048	83	26,852	41,460
2049	84	29,614	14,333
2050	85	15,193	0

Potential pitfalls
If Mr. Smith failed to name a beneficiary or he named his estate as the beneficiary, his son would have only up to five years from the date of death to remove the value from the IRA. This does not leave much planning opportunity.

If Mr. Smith names a trust as a beneficiary, there are numerous potential negative consequences for his son. In most cases it is best to name the beneficiaries of the IRAs by name. The son will either use the five-year rule to remove the IRA assets or in the best-case scenario, he may be able to use the remaining life expectancy of Mr. Smith. Obviously Mr. Smith’s life expectancy would be much shorter than his son’s. (Using trusts as designated beneficiaries is beyond the scope of this article. Additional information concerning trusts as designated beneficiaries can be found at www.ataxplan.com.)

The current custodian who holds the IRA may not honor the stretch technique. This pitfall is also your opportunity. Review the custodial agreement with every client who has an IRA. Not all IRA providers abide by the stretch. This creates an opportunity for you to gather the IRA assets and place them with custodians who do allow the stretch option.

The power of the stretch IRA allows you to focus on multigenerational planning opportunities for the families you serve. Learn how to use this powerful planning tool with your clients and help them keep the IRA in the family.

Gregory B. Gagne, ChFC, is a past president of NAIFA-New Hampshire and a member of MDRT. He may be reached at greg@affinityinvestmentgroup.com.