Stretch IRA: Definition, Evolution, And Exceptions
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Summary:
The stretch IRA, once a popular estate planning strategy for extending the tax benefits of IRAs to non-spouse beneficiaries, was effectively phased out in 2019. This article explores what the stretch IRA was, how it worked, and the key changes brought about by the SECURE Act of 2019. We’ll also delve into the exceptions, the 10-year rule for inherited IRAs, and the implications for beneficiaries. Understanding the evolution of this strategy and its impact on estate planning is crucial in the ever-changing world of finance.
What does stretch IRA mean?
The concept of a stretch IRA was an ingenious estate planning strategy designed to provide financial security and benefits to both the original account owner and their heirs. It allowed owners of Individual Retirement Accounts (IRAs) to pass on their accumulated assets to the next generation while leveraging the prolonged tax-deferred growth of the assets. However, this strategy underwent a significant transformation in 2019, effectively closing the door on its traditional usage.
Evolution of the stretch IRA
Under current law, beneficiaries of IRAs other than the spouse of the deceased must withdraw all of the funds in the account within 10 years of the death of the original account owner. This applies to IRAs inherited after Dec. 31, 2019.
Exceptions to the rule
Nonetheless, there are strictly-defined exceptions. If the beneficiary is a minor child, disabled or chronically ill, or is less than 10 years younger or older than the original account holder, a stretch IRA is still permitted.
Rules for the spouse
The spouse of the deceased follows different rules. The spouse must begin taking RMDs by the end of the year after the owner’s death or the year the owner would have reached the age for RMDs, which is 73 as of Jan. 1, 2023.
How a stretch IRA worked
A stretch IRA was not actually a type of IRA. Rather, it was a financial strategy, used mainly on traditional IRAs, that allowed people to greatly extend the period of time during which taxes on an IRA were deferred in order to benefit their heirs.
Calculating RMD
The RMD is calculated by taking the account balance on Dec. 31 of the previous year and dividing that number by the number of years left in the owner’s life expectancy, as listed in the IRS “Uniform Lifetime” table. Each year thereafter, the RMD is calculated by dividing the account balance by the remaining life expectancy.
The perks of a stretch IRA
Under the old rules, non-spousal beneficiaries had to start withdrawing funds from the IRA too—even those who inherited Roth IRAs, which don’t carry RMDs for the original account holder. But here was the good part: The heirs could base the RMDs on their own life expectancy. The younger the beneficiary, the lower the annual RMD.
Intergenerational wealth building
In general, the stretch IRA strategy was used by wealthy retirees who wanted to pass along a portion of an estate. It should be noted that the beneficiaries of inherited Roth IRAs are required to take RMDs, even though the original account holder did not have to. In any case, the distributions generally remain tax-free, while traditional IRA distributions are treated as ordinary income.
What is the point of a stretch IRA?
The stretch IRA was used primarily by wealthy individuals who wanted to pass along a portion of an estate to the next generation, or even the generation after that. The minimal requirements for withdrawing money meant that the inheritance could remain intact and grow for many years.
The 10-year rule for inherited IRAs
The 10-year rule requires that most people other than spouses who inherit the assets of an IRA must withdraw all of the money in the account before the end of the 10th calendar year after the death of the original account holder.
Spousal exceptions
A spouse who inherits an IRA must begin taking required minimum distributions RMDs by the end of the year after the owner’s death or the year the owner would have reached the age for RMDs. That age is 73 as of Jan. 1, 2023.
Understanding the transformation and eventual discontinuation of the stretch IRA is vital for anyone involved in estate planning or those who may inherit an IRA. Consultation with a financial professional is highly recommended, as the consequences for incorrect withdrawals or non-compliance with the updated rules can be significant.
The bottom line
The stretch IRA strategy is no longer in the toolbox for estate planners and their clients. Non-spouse beneficiaries of IRAs must now claim the entire balance in the account within 10 years of the death of its original owner. However, non-spouses who inherited IRA assets before Dec. 31, 2019, are grandfathered in. They can follow the old rule, which only requires them to withdraw an RMD based on their own life expectancy, not that of the original account holder.
Frequently asked questions
What was the stretch IRA?
The stretch IRA was an estate planning strategy that allowed non-spouse beneficiaries to inherit and extend the tax benefits of an IRA.
When did the stretch IRA strategy end?
The stretch IRA strategy was effectively phased out by the SECURE Act of 2019.
Are there exceptions to the 10-year rule for inherited IRAs?
Yes, exceptions include minor children, disabled individuals, and beneficiaries within 10 years of the original account holder’s age.
Can inherited Roth IRAs still benefit from the stretch IRA strategy?
No, non-spouse beneficiaries of inherited Roth IRAs are subject to the same rules and the 10-year withdrawal requirement.
What should I do if I have inherited an IRA?
If you have inherited an IRA, it’s essential to consult with a financial professional to understand the specific rules and requirements, as well as to avoid potential penalties for incorrect withdrawals.
Key takeaways
- The stretch IRA was an estate planning strategy for extending the tax benefits of IRAs to non-spouse beneficiaries.
- Non-spouse beneficiaries were allowed to base RMDs on their own life expectancy, providing an opportunity for intergenerational wealth building.
- The SECURE Act of 2019 effectively ended the stretch IRA strategy for most beneficiaries, introducing the 10-year rule for inherited IRAs.
- Exceptions exist for beneficiaries who are minors, disabled, or within 10 years of the original account holder’s age.
- Consulting a financial professional is crucial when dealing with inherited IRAs to avoid penalties for incorrect withdrawals.
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