When you’re thinking about your retirement savings, you may have wondered how you could pass your money on to second- and even third-generation beneficiaries. A stretch IRA could be the solution you need.
A stretch IRA isn’t an entirely different type of IRA. Instead, it’s a provision you can add to your current IRA whether it is a traditional IRA, Roth, SEP, or SIMPLE IRA. A stretch IRA permits your IRA to keep growing tax-deferred indefinitely because it can be passed from generation to generation.
To be a stretch IRA, the IRA needs to have two provisions. First, the IRA should allow you to designate a beneficiary who can elect to receive distributions based on a life-expectancy period. Second, the IRA should allow the beneficiary to select a second- or third-generation beneficiary. This is the provision that essentially makes it a stretch IRA.
To avoid an excess accumulation penalty, the primary beneficiary needs to withdraw a minimum amount every year based on the beneficiary’s life expectancy. The life expectancy of a 48-year-old beneficiary is 36 years, so there would be a $5,000 minimum required distribution on an $180,000 IRA. If that beneficiary passes away prematurely, the second-named beneficiary would continue receiving distributions based on the prior 36-year life expectancy.
The distributions could be stretched out even further if the original IRA owner named a second- or third- generation beneficiary from the beginning. For example, a 20-year-old beneficiary has a life expectancy of 63 and would receive a minimum $2,857 distribution for 63 years instead of the 36 years in the previous example.
A stretch IRA keeps your assets in the hands of your family and loved ones rather than your estate trustee who will likely pay out the IRA immediately, getting rid of the possibility for future tax-deferred growth.
You can make your beneficiary a millionaire. Assuming a 6% rate of return, a $150,000 IRA can pay out more than $1 million over 55 years. The younger the beneficiary, the greater the life expectancy, and the longer the IRA has to expand.
Unfortunately, tax laws aren’t promised for the next 60 years, so benefits of a stretch IRA are subject to changes in the tax law. At any point in the future, the IRS could change the rules regarding named IRA beneficiaries and minimum required distribution levels.
Your average rate of return should remain mainly constant to get the highest earnings on your IRA. A fluctuating rate of return will minimize IRA earnings, which means your beneficiaries may not become millionaires, but they still get the advantages of tax-deferred growth from your IRA contributions.