IRAs were designed to help people create a source of funds to finance their retirement needs. Yet the provisions of IRAs allow you to name a beneficiary to inherit your retirement savings after your death, and named beneficiaries have options they can use to stretch out distributions far into the future. These features have led to what's called stretch IRA planning. Required minimum distribution rules require every IRA to end eventually, but you can get decades or even generations of tax benefits before you stretch your IRA to the limit.
The lifespan of IRAs
Every IRA has a life cycle. The accumulation phase generally comes first, where contributions and rollover transactions add to account balances. Growth in investments also typically sends IRA balances higher over time.
Next, the distribution phase begins. That's when retirees need money from their nest eggs and start making withdrawals from their accounts. At the same time, RMD provisions force traditional IRA owners to start taking distributions when they turn 70 1/2. No such provisions apply to Roth IRAs, though, so not every IRA starts decreasing in value at this time.
Finally, if the original accountholder dies before spending down the entire IRA balance, then the beneficiary phase becomes the final period for the IRA. Spouse beneficiaries can roll over inherited IRAs into their own retirement accounts, while non-spouse beneficiaries have to take RMDs that will eventually result in the exhaustion of the account. However, the rules governing the beneficiary phase allow it to last for a period based on the life expectancy of the beneficiary. So if you have a young heir, the total time over which an IRA lasts could end up being 100 years or more.
Calculating what a stretch IRA looks like
The easiest way to look at how stretch IRAs work is with a simple example. Say that a 75-year-old has $250,000 in an IRA and has named a 25-year-old grandchild as beneficiary. The money is invested and earns 5% per year. The calculator below gives the results for this example.
Editor's note: The text that follows is provided by CalcXML, which built the calculator below.
The results show that the 75-year-old's life expectancy is about 13 years, at which point the IRA will have dwindled to about $220,000 because of required distributions. However, at that point, the young beneficiary gets a new RMD based on a much longer life expectancy, and that reduces the required distributions. That sends the account balance climbing higher over time, reaching a high of more than $340,000 when the beneficiary reaches age 63 before starting to decline. Based on the actuarial predictions, the stretch IRA will last until 2075, at which time the beneficiary will be required to withdraw the final portion of the account.
Things to keep in mind
Stretch IRAs allow you to maximize the length of time you get to keep money in an IRA, but it's important to understand that you're not obligated to follow stretch IRA rules. In particular, if you need more money than the required minimum distribution in any year, you're perfectly free to do so. The net result will be an accelerated drawdown of the account balance. But in situations in which you need money quickly, an inherited IRA is available to the heir in larger amounts.
Also, don't forget about the tax consequences of withdrawals. You're still required to pay tax on the money withdrawn from the account throughout the IRA's existence. In some cases, you might be better off not stretching out IRA distributions and simply paying all the prospective tax now -- especially if you're in a low tax bracket currently.
Even with these caveats, a stretch IRA is a great planning tool. By taking advantage of favorable tax provisions, a stretch IRA creates a legacy that your loved ones will thank you for long after you're gone.