If you own an IRA, leaving the balance to your children or grandchildren upon your death can greatly stretch its benefits — as long as you fill out a simple form and clearly communicate your wishes.

In this article, we’ll take a look at the so-called “stretch IRA” and explain how to take advantage of its benefits. (For information on stretching your 401(k), read this article.)

Stretch IRA basics

With a traditional IRA, you can begin taking penalty-free withdrawals at age 59½. If you don’t need the money that early, you can wait until age 70½, at which point you will have to begin taking required minimum distributions (RMDs). The federal government determines the amount of each distribution based on your life expectancy. Since distributions from a traditional (i.e, non-Roth) IRA are taxed as regular income, the government’s goal is to force complete distribution of your IRA’s assets before you are expected to die so that Uncle Sam can levy his taxes.

As beneficial as a tax-advantaged retirement account can be for you as it grows, it can be even more advantageous for a young heir. If you take the simple step of naming beneficiaries to your retirement account, those beneficiaries can choose to stretch the distributions over their life expectancies. That could save them significant amounts of taxes and enable them to grow the balance further on a tax-deferred basis.

The benefits of doing this with a Roth IRA are even greater. If you, as the original account owner, don’t need all of the money for retirement expenses, Roth rules do not require you to begin taking distributions at age 70½. That gives you the potential to continue growing the account tax-free. Because you’ve already paid taxes on the money you contributed, your beneficiaries could then stretch distributions over their life expectancy and grow the balance further on a tax-free basis. Unlike you, the beneficiary who inherits your Roth IRA upon your death does need to take RMDs. (Your account needs to have been open at least five years at the time of your death in order for beneficiaries to receive tax-free distributions on the account’s earnings.)

If you think it is likely that you will leave IRA assets to your heirs, the opportunity to make those distributions tax-free over their life expectancy may be a compelling enough reason to consider converting some or all of your IRA to a Roth. Of course, you’ll need the means to pay income taxes on the converted amount. Having a CPA or financial advisor run the numbers can often help you decide.

Beneficiary essentials

Your heirs’ ability to take advantage of a stretch IRA is highly dependent on designating beneficiaries properly.

If you are married and name your spouse as the primary beneficiary of your IRA, he or she will have several options upon your death. Your spouse could roll the money into his or her own IRA. If you were taking RMDs but your spouse is younger than 70½, this option would allow a delay in taking distributions until he or she is 70½.

A second option would be for your spouse to transfer your account to an Inherited IRA. The advantage here is that if your spouse is younger than 59½ and wants to begin taking distributions, he or she could do so without penalty.

Your spouse could also disclaim all or part of the assets so they can pass to other beneficiaries.

When a younger beneficiary (perhaps a child or grandchild) inherits an IRA, that beneficiary will be able to stretch the distribution of the assets over his or her life expectancy, and this is where the benefits of a stretch IRA become really significant.

The stretch IRA in action

Two scenarios will demonstrate the benefits of a stretch IRA.

  • Scenario 1: No IRA beneficiary form filled out.
    Assume Anna had an IRA worth $300,000 and she died at age 65. Although Anna specified in her will that she wanted her 40-year-old daughter Elizabeth to receive her IRA, she was not named as a beneficiary at the brokerage firm that held the IRA. Therefore, Anna’s IRA passed to her estate.

    Because Anna was under 70½, Elizabeth has to withdraw all of the assets by the end of the fifth year after Anna’s death. (If Anna had reached age 70½ and was taking RMDs, Elizabeth would have had to continue taking distributions on a schedule based on Anna’s life expectancy.) If Elizabeth spread the annual distributions evenly over the five-year period, she would eventually withdraw a total of approximately $380,000 (assuming 8% annual growth). From this, she would pay taxes of roughly $106,400 (assuming a personal tax rate of 28%). There is also the possibility that receiving this additional income could bump Elizabeth into a higher tax bracket, making the tax liability even greater. At the end of the five years, the IRA is empty.
  • Scenario 2: A properly designated beneficiary.
    Under this scenario, when Anna died, Elizabeth became the immediate owner of the IRA and she was able to sidestep the five-year rule.

    According to the IRS life-expectancy tables, Elizabeth is expected to live another 43.6 years, so her RMD in the first year is approximately $7,400 ($300,000 times 8% growth, divided by 43.6). This means about $2,100 would be due in taxes. By the end of the first five years, Elizabeth will have had to pay only $12,200 in taxes. Elizabeth will be able to postpone paying more than $94,000 in taxes during the five-year period, allowing the IRA money to continue working on her behalf.

    Despite annual withdrawals, the IRA will have grown to about $400,000 by the end of the fifth year, whereas in Scenario 1 the IRA would have been depleted. Assuming

    Elizabeth chooses to take only the minimum distributions required, her IRA would grow to nearly $900,000 by age 65.

    As the example shows, the importance of properly naming beneficiaries of an IRA cannot be overstated! But just because you take all the right steps to make sure your beneficiaries are eligible to take full advantage of a stretch IRA doesn’t mean they will actually do so.

Communicating with beneficiaries

They will have the option — and may be tempted — to take all of the money out of the IRA right away, thereby negating all of the tax and potential compounding benefits they would have received by stretching distributions over their life expectancy. So, be sure to communicate your intentions with your beneficiaries or those responsible for managing money on their behalf.

If a minor inherits your IRA, a property guardian named in your will or a trustee named in your trust will be responsible for making sure the assets are managed according to your wishes. In the case of a will only, the guardian’s influence in making sure your wishes are fulfilled may end when the minor reaches the age of majority (18 or 21, depending on state law). In the case of a trust, the trustee’s ability to carry out your intentions can continue longer. (A trust must meet the definitions of a “see-through” trust in order for the beneficiaries to be able to stretch their RMDs.)

The stretch IRA’s days may be numbered

Where there are tax savings to be found, very often there are lawmakers looking for ways to close those “loopholes.” In recent years, proposals have been floated that would require non-spouse IRA beneficiaries to distribute the full account balance by the end of the fifth year after the original account owner’s death. At present, this idea is still in the proposal stage, but it’s worth keeping an eye on the issue.

Final thoughts

Preparing an IRA to become a stretch IRA after your death is tremendously advantageous for your beneficiary, but doesn’t inhibit your flexibility at all. If you need to withdraw more from your IRA than the RMDs at any point, you can. And if you want to change beneficiaries, you may do so at any time. There’s no downside.

There are additional rules governing inherited IRAs, so before making final decisions about leaving or (especially) receiving IRA assets, it is beneficial to consult with an estate-planning attorney or other advisor with expertise in this area.