A "stretch" IRA is simply an Individual Retirement Account that is preserved as long as possible by minimizing account distributions. A stretch IRA is used both to avoid income tax and to provide for heirs. While ultimately all IRA accounts must be distributed, judicious use of account distributions and beneficiary designations can help to extend the effective life of the IRA.
How IRAs Work
IRAs are tax-advantaged, long-term savings accounts. Usually contributions to the accounts are tax-deductible, and withdrawals are taxable at ordinary income tax rates. To ensure that IRA funds are ultimately taxed, the IRS requires distributions from the accounts at some point. The longer that distributions can be deferred, the more time the account has to grow in value and the lower the tax liability to the account holder.
Required Minimum Distributions
Required minimum distributions (RMD) are mandated by the IRS once you turn age 70 1/2. Specifically, distributions must begin by April 1 of the year after you turn 70 1/2 and must commence on an annual basis thereafter. The amount of the RMD is calculated by dividing your year-end account value by your life expectancy, as determined by the IRS tables in Appendix C of IRS Publication 590.
Spousal IRAs
A spousal IRA is the first step in transforming an IRA into a stretch IRA. Whereas the IRS mandates that some beneficiaries take a complete distribution of an inherited IRA within one year, a spouse is allowed to treat an inherited IRA as if it is his own. In other words, a spouse beneficiary is allowed to retitle the account into his own name, make contributions, rollover assets or take distributions as he sees fit. Even if the original account owner was already taking RMDs, a spousal beneficiary is only required to take RMDs once he is over the age of 70 1/2 himself. Particularly for a younger spouse, this can immediately extend the life of the IRA by 20 years or more.
Choosing Beneficiaries
The next step in creating a stretch IRA is for the spousal beneficiary to choose his own beneficiaries. In order to maximize the life of the IRA, the spousal beneficiary should choose the youngest appropriate beneficiary. According to the IRS tables in Publication 590, account owners must compute life expectancy by combining the expectancies of the account owner and his beneficiary. Thus, the younger the beneficiary, the longer the combined life expectancy and the smaller the amount of the required RMD. A smaller RMD not only keeps the greatest amount of assets in the IRA, it also extends the payments over a longer time period.
IRA Beneficiary Rules
The benefits of a stretch IRA end when the beneficiary of the spousal IRA receives the assets. Unlike with spousal IRAs, the non-spouse beneficiary cannot name new beneficiaries, and the account must begin to pay out immediately. The most advantageous payout for a non-spouse beneficiary is to take RMDs over her own life expectancy, rather than that of the original account owner. According to IRS tables, a 21-year-old beneficiary has an additional 62.1 years to extend the life of the IRA, thus stretching the lifetime of the IRA assets further still.
