Surprise: This tax-savvy strategy can be used whether or not you convert a traditional IRA to a Roth IRA.
I was a guest on an estate planning radio show recently when a listener from Traverse City, Mich., phoned with an eye-opening question. "Do I have to convert a traditional IRA to a Roth to make it a 'stretch' IRA?" she asked.
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The short answer is: Absolutely not. But what a wake-up call! It made me realize that, with all the talk this year about Roth conversions, plenty of well-informed people are understandably confused about this issue.
First, keep in mind that the term "stretch" does not denote a specific type of IRA, but rather a financial strategy to stretch out the life -- and hence the tax advantages -- of an IRA.
Before Congress created Roth IRAs, the term "stretch IRA" was used to describe the strategy in which a spouse, child or grandchild inherits a traditional pretax IRA and then draws out distributions (and hence tax deferral) over his or own life expectancy. The longer the life expectancy, the smaller -- as a percentage of the IRA balance -- each payout must be.
With a traditional IRA the money is taxed as it is taken out of the IRA wrapper, whether by the account owner or beneficiaries. So stretching out the IRA gives the funds extra years -- potentially decades -- to compound tax-deferred -- a wonderful investment opportunity.
With the emergence of the Roth (and beginning this year, the availability of Roth conversions to taxpayers at all income levels), there are now more ways for IRA owners to stretch out tax benefits for themselves and their heirs. There is also, no surprise, more confusion.
Here's what you and family members can do to maximize tax savings.
What IRA Owners Can Do
With a traditional IRA the owner must start taking withdrawals by April 1 of the year after turning 70 and a half. Calculating this required minimum distribution (RMD) is usually fairly straightforward. You take the account balance on Dec. 31 of the previous year and divide it by the number of years left in your life expectancy, as listed in the Internal Revenue Service's "Uniform Lifetime" table.
For example, if Sally, a widow, will be 75 in 2010 and the account balance at the end of last year was $100,000, the RMD for this year is $100,000 divided by her remaining life expectancy of 22.9 (from the IRS table), or $4,366.81. Each year she must take another withdrawal, computed the same way. (If Sally has remarried and her husband is more than 10 years younger and the sole beneficiary of her IRA, she can use the "Joint Life and Last Survivor Expectancy" table instead, and her RMD each year would be smaller.)
Here's where the Roth confusion comes in. In a Roth conversion you move money from a traditional IRA to a Roth IRA, paying ordinary income taxes (preferably with non-IRA funds) on whatever amount you shift. You don't have to take yearly minimum distributions from the Roth, and future growth in it is tax-free, as are future withdrawals. That means unless you need to withdraw the money to live on, there will be more left in the IRA for your heirs to stretch out.
So by converting to a Roth, you can leave a larger IRA to your heirs and it will be a tax-free, rather than a tax-deferred, IRA. That's why you've been hearing so much about Roth conversions and their advantages for those affluent enough to leave money to heirs.
The other thing that influences the value of a stretch-out for your family is your choice of beneficiary. You must indicate this on the beneficiary designation form you fill out when you open the account. (You can later amend this form. If you opened the account long ago, check the form you have on file to make sure it's what you intend.) Money in an IRA is distributed according to this form, not your will.
Non-spousal heirs, regardless of their age or the type of IRA, must take RMDs; a Roth conversion eliminates RMDs for you, but not for them (more lenient rules apply to spouses). These RMDs are based on the heir's life expectancy, so the younger the beneficiary, the less he or she must take out each year. Therefore, if maximizing the stretch-out is the main goal, the best person to designate as a beneficiary is someone young.
One thing you should never do is name your estate as the beneficiary--a mistake even smart, highly educated people have made. If you do, under the worst combination of circumstances, funds might have to be withdrawn within five years of your death. With a traditional IRA all the income tax would have to be paid as the money comes out of the IRA. This could also happen if you do not name a beneficiary at all, or if no one can find the beneficiary designation form when the time comes.
Make sure to also name contingent beneficiaries. If you don't and your named beneficiary dies before you, the money will revert to the estate.
What IRA Beneficiaries Can Do
For better or worse, IRA owners can't control whether inheritors take maximum advantage of the stretch-out. Any heir except a spouse must begin taking withdrawals starting on Dec. 31 of the year after he or she inherits the account. The required withdrawal is computed the same way as it is for owners, but using a different IRS table known as the "Single Life Expectancy" table.
Consider Harry, who leaves part of his IRA, worth $100,000, to his grandson, who is 21 when Harry dies at age 69. The grandson must begin taking RMDs the year following Harry's death but can stretch out withdrawals for the rest of his life. Based on an account balance of $100,000, the grandson's first required distribution at age 22 is $100,000 divided by his life expectancy of 61.1 years (from the IRS table), or $1,636.66.
If he continues to withdraw just the RMD each year, and the investments appreciate at a steady rate of 6%, this inheritance will be worth $342,854 by the time the grandson reaches age 65 -- and could provide a tidy nest egg for his own retirement, according to calculations by Brentmark Software.
But what if the self-indulgent grandson cashes the money out early to buy a BMW? Or what if he needs it to help finance the purchase of a house or a child's college education? In financial lingo this is called "blowing the stretch-out." And in real life it happens all the time. The grandson will owe ordinary income taxes, or if it's a Roth, no taxes. But there's no "early withdrawal" penalty as there might be if he were taking money from his own IRA before retirement.
What Spouses Can Do
Most married people name their spouse as beneficiary of an IRA, and the law gives a spousal inheritor special privileges. A spouse -- let's assume it's the wife -- can roll the assets into her own IRA. For a traditional IRA that means she can postpone RMDs until the year after she turns 70 and a half. Or after rolling over the IRA she can convert it to a Roth and eliminate the need to take withdrawals altogether. If she has inherited a Roth, she can achieve the same effect by simply rolling it into her own name.
Still, unless your spouse is much younger than you are, the potential stretch-out is shorter than if you named a child or grandchild as the designated beneficiary. Sometimes there's no alternative -- for example, your spouse might need the money. If you cannot be sure ahead of time, keep your options open: Make your spouse the primary beneficiary and name a younger person as the contingent or alternate beneficiary. (Again, you must do this on the beneficiary designation form.) When you die, your spouse can decide whether to inherit the IRA directly and roll it over into his or her own IRA, or disclaim (turn down) the inheritance. In that case it would pass to the younger beneficiary you named, who can take a longer stretch-out.
Note that if you haven't named a contingent beneficiary, your spouse won't have this option. And in any event, he or she can't decide who gets the IRA in case of a disclaimer. It's something only you can map out in advance when you fill out the beneficiary designation form.
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide (DJWorking Unlimited, 2009). To learn more, visit estateplanningsmarts.com.