Stretching Your IRA: Transferring Wealth to the Next Generation
June 30, 2009
Updated from the winter 2008 issue of On Investing, a magazine for Schwab clients.
If you're like millions of Americans, you already know that an IRA can be a powerful way to save for retirement. What many people don't know is that an IRA can also be an effective estate-planning tool, allowing you to transfer wealth to future generations while reducing, deferring or even eliminating income taxes on your retirement savings. Thanks to changes in the distribution rules for qualified employer-sponsored retirement plans and IRAs, a strategy of stretching your IRA, sometimes called a “stretch IRA,” can help you extend the account's tax-free compounding to your beneficiaries. While this won't be a practical solution for everyone, it may be a useful option to consider as you create or update your estate plan.
Who can benefit from stretching an IRA?
The goal of stretching an IRA is to strategically transfer as much of your retirement savings as possible to your heirs, while minimizing the impact of income taxes on their inheritance. Anyone who has younger beneficiaries or beneficiaries whom they expect to outlive them—such as a younger spouse—can benefit from a stretch IRA. Keep in mind that stretching your IRA works best when you (the account owner) don't need the money in your IRA either before or after retirement to pay for living expenses or other retirement costs.
Making it work for you
You can typically implement a stretch IRA strategy with a new or existing IRA by simply naming one or more beneficiaries who are younger than you. You take only the required minimum distributions (RMDs) during your lifetime, leaving the remainder to continue growing tax-deferred while you are still alive.
If you're married, you may want to consider naming your spouse as your primary beneficiary and your children or grandchildren as secondary beneficiaries. Whether you're married, single or divorced, you can name anyone you choose as beneficiary, including family members, friends, a charitable organization or a family trust. Keep in mind that if your ultimate goal is preserving wealth for future generations, a stretch IRA strategy will generally allow you to transfer more money to younger beneficiaries when your primary account beneficiary dies before he or she can deplete the account, allowing other beneficiaries to inherit what remains.
Stretching out account distributions
Upon your death, your beneficiaries will generally have at least two or more distribution options, depending on whether they are spousal or non-spousal beneficiaries and whether or not you had begun taking RMDs from your account.
Your beneficiaries' distribution options may include:
- Taking a lump-sum
- Transferring the account balance to an inherited IRA with a five-year time limit for starting distributions
- Transferring the account balance to an inherited IRA that distributes assets according to the beneficiary's life expectancy.
Spousal beneficiaries have the additional option of requesting a spousal transfer, allowing them to roll over the account balance into an IRA in his or her own name. To learn more about distribution options, read our Inherited Retirement Account Guide.
Roth vs. traditional IRAs
Stretching an IRA can be even more effective if you contribute to a Roth IRA. (To determine your eligibility, use Schwab's IRA Analyzer. While Roth IRA contributions are not tax deductible, your investments grow tax-free, earnings can be withdrawn income-tax-free if you're at least 59½ and have had the Roth at least five years, and there are no RMDs at age 70½. Because of these benefits, using a Roth IRA for your stretch IRA strategy may be a smart choice if you have significant IRA balances that you don't plan to tap during your lifetime.
Although the value of a Roth IRA will be included in your estate, the account could grow larger than it otherwise might under traditional IRA distribution rules, potentially leaving more money for your heirs. Also, your beneficiaries can make income-tax-free withdrawals during their lifetimes (an added bonus for them if you prepaid the income tax on their behalf from your taxable estate by converting unneeded traditional IRAs to Roth IRAs during your lifetime).
The flexibility to change your mind
As with any estate-planning technique, your plans—and the tax laws—may evolve over time. If you're unsure whether or not you'll need your IRA assets to fund your own retirement, you can still implement a stretch IRA strategy and adjust your plans later as needed. All IRAs give you the flexibility to begin taking penalty-free distributions as early as age 59½. In addition, you can change the beneficiary at any time should your beneficiary's needs change or if you decide to use a different wealth-planning strategy. If you have questions about which IRA and estate-planning techniques are right for you, you may want to discuss your options with your tax advisor, as well as with your attorney.
As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized advice.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment manager.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.