Is a ‘stretch’ IRA right for you?

Examine the costs and benefits of stretching your IRA

By InvestorPlace Nov 19, 2010 3:51PM

By Chuck Epstein,

Mutual funds information and IRA information is becoming a hotter commodity by the day.

Too many New Year’s resolutions never get realized, but if you want to increase your odds of attaining a more fruitful financial future for you and your heirs, you should consider a stretch IRA.

The tax laws governing Individual retirement Accounts (IRAs) are very specific, but by applying a different type of strategy you and your beneficiaries can reap some significant benefits. This strategy is called a “stretch” IRA and it can be done by almost anyone who owns an IRA.

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The idea is to name younger beneficiaries and then split your IRA into smaller IRAs so the withdrawal period can be “stretched out” over the lifetime of the other beneficiaries.  When this stretching happens, the assets in the beneficiaries’ account grow tax-deferred over the longer life spans of the younger beneficiaries. Since Albert Einstein called compound interest “the greatest mathematical discovery of all time,” it has been successfully employed in the stretch IRA, which uses a distribution based on the longer life expectancies of the beneficiaries.

By contrast, in a standard IRA when an IRA beneficiary dies and gives an equal amount to a spouse and a child, the distributions are based on the lifespan of the oldest beneficiary.  Since tax deferred compounding is so powerful, the stretch strategy could produce a significant return, especially when it is bequested to a young beneficiary.

To set up a stretch IRA, make sure you do the following:

  • Choose your beneficiaries correctly.  This strategy works best when people who are young enough to take full advantage of tax-deferred growth over time.
  • Establish separate IRAs for each beneficiary and combine your IRA assets.  If you have a 401(k), consider rolling that into your IRA.  Your IRA should then be divided into separate IRA accounts for each person you name as a beneficiary.
  • Tell your beneficiaries about this strategy.  This account will be registered in your name.  Be careful that the account registration is correct since this could violate the “stretch” provision, and its benefits.
  • Get professional help. While the concept is simple, setting up a stretch IRA requires professional assistance.  Mistakes can trigger serious consequences, which result in overpayments or, at worse, voiding the gains of an entire lifetime of asset accumulation by paying penalties and additional taxes.

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The assistance of a trained professional is important. Even within the stretch IRA category, this structure has different features in a traditional IRA, Roth IRA, or when using spousal or non-spouse beneficiaries as part of an overall estate plan.

Other Common IRA Mistakes to Avoid

While IRAs present good opportunities for tax deferrals, there are very specific conditions which must be met in order to reap the benefits of an IRA.  Here are five guidelines that highlight common mistakes to avoid, according to Ed Slott, a CPA and nationally-recognized authority on IRA distributions.

1. Stay Current on IRA Regulations.

The IRS regularly interprets regulations and rules through private letter rulings, exemptions and case law.  These changes affect current tax regulations and how beneficiaries are treated.  Common mistakes can be costly.  For instance, one financial advisor did not act quickly enough when managing an IRA rollover because he took longer than the 60-day allotted period. This resulted in a costly penalty for the innocent beneficiary.

2. Mind Inheritance Rules of IRAs.

The IRS has specific rules on who can inherit and IRA and how they should receive it.  I one frequently cited case, a woman inherited a $400,000 IRA from her father.  Her broker told her to roll the IRA directly into her own IRA.  This was a mistake.  The IRS says that once inherited IRA funds are distributed to non-spousal beneficiaries, the tax-sheltered status ends and the distribution becomes taxable.

3.  Take Advantage of Tax Breaks

IRS regulations are complex and frequently change.  As a result, many professionals, including accountants and lawyers, may not know about all the tax breaks available to individuals.  One good example concerns something called “Income in Respect of a Descedent.”  This provision says that if an IRA is inherited from an estate that pays federal estate tax, the beneficiary is eligible to deduct about 40% of the IRA’s income tax.  This is a deduction which is commonly overlooked by accountants.  In one case, Slott reviewed a client’s situation and saved her $838,000 in missed deductions, even after she had paid her lawyer $50,000 and they still missed this deduction.  

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4. Take Time to Accurately Complete Custody and Beneficiary Forms

While this looks like a simple process, something as easy as checking the wrong box can have serious, expensive consequences, according to Slott.  This can mean that people should frequently update their beneficiary forms, due to deaths in the family or divorces, for instance.  In one case, a woman died and left her $1 million retirement plan to her husband in her will.  But years before, the woman named her sister as the sole beneficiary.  The beneficiary document over-rode the will, so the sister got to keep the money.

5.  Use Trusts to Distribute Proceeds

Trusts are a time-tested method of distributing money over time to named beneficiaries. Trusts can preserve the intentions of the deceased and keep the money working longer for beneficiaries over time, especially if the beneficiaries have proven they cannot control their spending.  While trusts are proven, they also create tax and accounting issues.

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