What is a Stretch IRA?

Written By Cathy Lovering
Last updated July 12, 2021

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Investing
July 12, 2021

Simple. Thrifty. Living.

An IRA is a common and effective retirement savings and tax management strategy. So if you’re wondering what is a stretch IRA, you might be looking for a new way to make the most of your estate dollars. A stretch IRA isn’t a specific type of retirement savings account. It is a way for IRA account holders to confer tax savings onto beneficiaries.

With the SECURE Act of 2019, the government largely got rid of stretch IRAs. But some people are grandfathered into the old system or fall within exceptions to the new rules. Here’s more information about what is a stretch IRA, and some alternative ways to provide a financial legacy to loved ones.

Start With Required Minimum Distributions

Once you reach a certain age, you must start taking money out of your IRA. That’s the IRS rule, for most people starting at age 72. The IRS calculates these mandatory withdrawals — called required minimum distributions — based on standard tables that consider certain criteria such as your life expectancy.

Everyone has a different minimum they must take out every year, so a lower minimum means you can let the rest of your contributions grow inside your IRA.

The IRS taxes these mandatory withdrawals as ordinary income. That means the tax deferrals you have benefitted from over years of contributions finally come back, as the IRS gets to take a portion of those IRA distributions.

Stretch IRAs Are Left to Young People With Low RMDs

With a stretch IRA, the difference came down to the beneficiary. Prior to the SECURE Act, a non-spouse IRA beneficiary had to follow RMD rules based on their own life expectancy — not that of the original account holder. It became common practice for IRA holders to name the youngest family member as IRA beneficiary.

If the account holder’s surviving spouse was already financially secure, it simply made sense to leave the IRA to a young person. They could stretch out their RMDs over a longer time, benefiting from lower taxes — assuming the younger person is in a lower tax bracket than an older one — and giving the remaining funds in the IRA time to grow on a tax-deferred basis.

Now, after the changes of the SECURE Act, most IRA beneficiaries have to take out all the funds within 10 years. The penalty for not doing so is facing taxation on the entirety of the IRA all at once. Notably, beneficiaries do not have to take out any money over the course of the 10-year period if they choose not to; they can do it all at once as this window comes to an end. But by the end of 10 years, the IRA must equal zero.

The SECURE Act largely did away with the old regime, but not entirely. So what is a stretch IRA is still a valid question. Consider these two categories of people:

  • Non-spouse IRA beneficiaries of IRA accounts whose holder passed away Dec 31, 2019 or earlier;
  • Beneficiaries who fall into the exceptions of the new SECURE Act rules.

Both of these groups can still use the old stretch IRA rules.

Beneficiaries Grandfathered into the Old System

Anyone who inherited an IRA before Dec 31, 2019 can continue to stretch RMDs based on their age and life expectancy as determined by the IRA. That’s the “stretch” in the question, “what is a stretch IRA” — it’s about stretching those distributions.

So even if the beneficiary was 20 years old when they inherited the IRA on, as an example, Dec 1, 2019, they can continue to keep the funds in their IRA largely intact over subsequent decades. The law does not require them to take out the balance within a shorter time period.

Exception Categories of the New SECURE Act Rules

The second group of people can also avoid the new rules. Examples of people who fall into the exception categories are:

  • A surviving spouse
  • A person not more than 10 years younger than the IRA account holder
  • A disabled person
  • A chronically ill person

Special Rules for Minor Children

If the plan beneficiary is a minor child, the RMDs are based on the child’s life expectancy until they turn the age of majority in their state. At that point, the 10-year-rule applies and they must withdraw the rest of the IRA by the end of that time. If the individual is in school, the 10-year-rule does not kick in until they reach the age of 26.

For anyone who wants to create a new plan for future heirs, it may be worth carefully considering other options to pass down wealth. Here are some ideas:

  • Bequeath other non-IRA assets, like real estate or stocks
  • Convert a traditional IRA to a Roth IRA prior to inheritance
  • Leave a traditional IRA to charity

Roth IRAs

Roth IRAs are built from contributions based on after-tax income. If you decide to switch from a traditional IRA to a Roth IRA, try to do so in small amounts over time. Each conversion from a traditional IRA to a Roth IRA is taxable income and doing a large conversion all at once can put you in a higher tax bracket.

Once you make the conversion from traditional to Roth IRA, your beneficiary gets a tax-free inheritance. The SECURE Act means they still have to empty the account within 10 years, unless they fall within an exception category. But when they do make withdrawals, those funds are tax-exempt.

Another option is to make a charity the beneficiary of your traditional IRA. Even though the charity must still adhere to the 10-year-rule, they won’t have to pay tax on distributions. This may be a sensible option for people who plan to include giving in their estate planning.

All of these come with their own tax implications. Since everyone has different financial goals, consider an in-depth conversation with a lawyer, tax expert, or qualified financial advisor before making changes. The key is that now you know what is a stretch ira, and you have options. You may still use this strategy in some cases, or you may have other alternatives. Make the choice that’s best for you and your loved ones.

About the Author

Cathy Lovering

Catherine Lovering has written about personal finance and health for over 10 years, with bylines on IvyExec.com and Healthline.com. She holds an LL.B. (J.D.) from the University of Victoria.

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