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Stretch IRAs

These tools offer your clients powerful planning techniques.

By Gregory B. Gagne, ChFC, Aug. 2005

The single largest asset for many retirees other than their primary residence is their IRA. But most are completely unaware of the tax nightmare that awaits the beneficiaries of these accounts if the account holders have not properly established a plan to pass this tax-deferred asset to their spouses and children.

In 2001, the IRS overhauled the rules pertaining to mandatory distributions from IRAs; as a result, some excellent planning opportunities are available for the informed advisor. Today, with proper planning, your clients’ IRAs can live on for their families long after they are gone.

After an IRA owner’s death, a spouse can roll the IRA into his name. This spousal rollover is not a change in the rulings, but what can happen next is!

If the surviving spouse names a designated beneficiary of the IRA, the beneficiary can withdraw the funds from the IRA over his life expectancy after the parent dies. The planning potential of this technique is tremendous. Under the old rules, the beneficiary would simply cash out the parent’s IRA and pay the income taxes on the distribution, resulting in massive taxes for most beneficiaries.

Your clients’ IRAs can live on for their families long after they are gone.

With the new rules, the beneficiaries have a planning opportunity to take simply the required minimum distribution (RMD) based on their life expectancy, and the remaining account balance can continue to grow on a tax-deferred basis. The beneficiary can elect to remove more than the required distribution at any time if he needs additional funds.

The planning opportunity
Mr. John Smith, age 65, has an IRA valued at $100,000. Let’s assume that he earns 6 percent on this IRA and will be taking only his RMDs once he is age 70½. Assume he has one child whom he names the beneficiary of his IRA. His child (Bill) is age 40. Mr. Smith’s required distribution schedule will look like this:

Mr. John Smith’s IRA
Assuming 6% Return on Investment and Taking Only RMDs
Year Age Required Distribution Account Value 12/31
2005 65 $ 0 $106,000
2006 66 0 112,360
2007 67 0 119,102
2008 68 0 126,248
2009 69 0 133,823
2010 70 4,884 136,968
2011 71 5,169 140,017
2012 72 5,469 142,949
2013 73 5,787 145,738
2014 74 6,123 148,359
2015 75 6,479 150,782
2016 76 6,854 152,976
2017 77 7,216 154,938
2018 78 7,632 156,602
2019 79 8,031 157,967
2020 80 8,447 158,998
2021 81 8,883 159,655
2022 82 9,337 159,898
2023 83 9,810 159,682
2024 84 10,302 158,961
2025 85 10,741 157,758

 

Now let’s assume Mr. Smith lives until age 85. When he dies, his son will be 61. His son has two choices. First, he can simply cash out his dad’s IRA (no stretch) and pay the income taxes due.

With no stretch planning, Bill will inherit $116,528, but with the stretch IRA planning, he will inherit $306,912. (The calculation assumes son is married, is filing a joint return and has taxable income of $50,000, excluding the required distributions.)

Bill must begin taking required distributions from his father’s IRA based on his own life expectancy starting the year following his father’s death. His father’s IRA is now worth $160,758, and his son, now age 61, must take a minimum distribution of $6,465.

Lump Sum Account Liquidation in 2026
Total distributions $157,758
Federal income tax on total distribution $41,230
Net after-tax to Bill $116,528
Over 26 percent lost to taxes  

Or he can stretch the IRA.

Required Distributions From 2026 Through 2050
Total distributions $367,647
Federal income taxes $ 60,735
Net after-tax income $306,912
Only 16.5 percent lost to taxes  

Bill must be listed as a designated beneficiary on the IRA beneficiary-election form for the stretch option to be valid. The easiest way to understand a designated beneficiary is that he is a beneficiary with a birth date. When the son notifies the custodian of the death of his father, he will most likely need to furnish a certified death certificate and also establish a beneficiary IRA with the custodian. At that time, the IRA provider will move the assets from the decedent’s IRA into the “inherited” IRA account. Keep in mind the account will stay in the name of the deceased for the beneficiary’s benefit but does not roll over into the son’s IRAs.

Mr. Bill Smith’s Inherited IRA
Assuming 6% Return on Investment and Taking Only RMDs
Year Age Required Distribution Account Value 12/31
2026 61 $ 6,465 $160,758
2027 61 6,870 163,534
2028 63 7,301 166,045
2029 64 7,759 168,249
2030 65 8,247 170,096
2031 66 8,768 171,534
2032 67 9,322 172,503
2033 68 9,914 172,940
2034 69 10,545 172,771
2035 70 11,219 171,918
2036 71 11,939 170,295
2037 72 12,709 167,804
2038 73 13,533 164,339
2039 74 14,416 159,784
2040 75 15,364 154,007
2041 76 16,384 146,864
2042 77 17,484 138,192
2043 78 18,675 127,809
2044 79 19,970 115,507
2045 80 21,390 101,047
2046 81 22,965 84,145
2047 82 24,749 64,445
2048 83 26,852 41,460
2049 84 29,614 14,333
2050 85 15,193 0

Potential pitfalls
If Mr. Smith failed to name a beneficiary or he named his estate as the beneficiary, his son would have only up to five years from the date of death to remove the value from the IRA. This does not leave much planning opportunity.

If Mr. Smith names a trust as a beneficiary, there are numerous potential negative consequences for his son. In most cases it is best to name the beneficiaries of the IRAs by name. The son will either use the five-year rule to remove the IRA assets or in the best-case scenario, he may be able to use the remaining life expectancy of Mr. Smith. Obviously Mr. Smith’s life expectancy would be much shorter than his son’s. (Using trusts as designated beneficiaries is beyond the scope of this article. Additional information concerning trusts as designated beneficiaries can be found at www.ataxplan.com.)

The current custodian who holds the IRA may not honor the stretch technique. This pitfall is also your opportunity. Review the custodial agreement with every client who has an IRA. Not all IRA providers abide by the stretch. This creates an opportunity for you to gather the IRA assets and place them with custodians who do allow the stretch option.

The power of the stretch IRA allows you to focus on multigenerational planning opportunities for the families you serve. Learn how to use this powerful planning tool with your clients and help them keep the IRA in the family.

Gregory B. Gagne, ChFC, is a past president of NAIFA-New Hampshire and a member of MDRT. He may be reached at greg@affinityinvestmentgroup.com.

 


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