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The Stretch IRA
February 2007
The facts are abundant. The proportion of retirees is growing dramatically. Between the years 2010 to 2030, the 65 plus population is expected to spike by 75% to more than 69 million. Furthermore, if you are married and make it to age 65, there is a 47% chance that one of you will live to see your 96th birthday. With 7,918 boomers turning 60 each day we should be focusing on retirement income planning. We first need to ensure we can't outlive our income. Next, we need to be certain all remaining funds are distributed to our designated beneficiaries in the way we want with minimal taxation.
No matter the type of qualified tax deferred retirement account you have, (IRA, 401k, 403b, Profit Sharing, Defined Benefit Plan) there are basically only two phases - the accumulation phase and the de-accumulation or distribution phase. During the accumulation phase all interest accumulates and compounds tax deferred. During the distribution phase income taxes are due April 15 of the year following the distribution. The year after you turn 70 ½ the IRS requires that you as the account owner begin receiving Required Minimum Distributions (RMD) based on the account balance on April 1 of each year. If the minimum distribution is neglected, an enormous 50% "too late, too little" penalty tax is imposed.
RMD Table Reduced Over 50% in 2002
Fortunately in 2002 the Required Minimum Distribution Uniform Lifetime Table published by the IRS was significantly reduced from 7% to a shade over 3%. For example, for every $100,000 in account value at age 71, $3,774 annually must be withdrawn verses $7,225 that was required prior to 2002. Today an 80 year old must receive $4,525 each year and an 85 year old $4,630 per $100,000.
If you are planning to only withdraw the Required Minimum Distribution from your retirement account, chances are you will leave an account balance to your beneficiaries. Today there are annuities available that guarantee a lifetime return of 3% to 6%, insuring that if no additional withdrawals are taken from your "qualified" account your beneficiaries will receive a sizeable inheritance.
This factor alone has created a greater need to properly plan the non-spousal distribution of your retirement accounts. What most people don't realize is that with little pre-planning their "qualified accounts" can be stretched out over multiple generations. And you can control the distribution to your heirs through predetermined beneficiary distribution elections. By failing to preplan you could actually forfeit up to 70% of the remaining balance to the IRS, in the form of estate and income taxes.
Below is a hypothetical example to illustrate the mechanics of a Stretch IRA:
Robert Simpson is a 65 year old engineer, with $500,000 in an IRA that he rolled over from a 401k he had with a previous employer. His wife Jean is 62. They have two children, Steve, 40 with no dependents and Rachael, 37 who has 3 children. Their son Steve has a difficult time with money and usually spends it as fast as he gets it. Rachael and her husband on the other hand are very responsible and do very well.
With the income he will receive as a consultant, his social security and pension payouts from another source, Robert has no need to withdraw from his IRA. He plans on letting it continue to compound until Required Minimum Distributions are required in five years. He has listed Jean as his primary beneficiary and his children as the secondary (contingent) beneficiaries.
Assuming his IRA compounds at 5%, his account value in five years will have grown to $638,141 with an RMD at year end of $23,290. His life expectancy is 21 years or to age 85, his total RMDs through the years would have paid out $531,156 and the account balance at death would be $641,587. Jean would be 83 years old at that time and would roll Robert's IRA into her own account and begin RMDs lasting until her passing at age 88 or another 6 years for a total distribution of $257,123, leaving a balance of $569,605 to be inherited by the children. If properly pre-planned Rachael can take her half - $284,803 and chose one of the following options:
- Take full distribution and pay income taxes the next April.
- Pass the inheritance onto her children or grandchildren.
- Receive the distribution over five years and pay income taxes on each withdrawal.
- A new option - Roll the account value into a newly created personal IRA. Note: No matter how old the non-spousal beneficiary is the RMD must begin based on their age and the RMD table. Furthermore, the non-spousal beneficiary must roll the inherited funds into a separate personal IRA and be a trustee to trustee transaction. In other words it must be a pre-selected option on the IRA or 401k beneficiary designation form and no funds can be personally received and then transferred. It can't be an afterthought. If she elected to stretch her father's IRA that she inherited from her mother, she would receive a total payout of $527,979 throughout her life expectancy verses $284,803 lump sum, minus 35% in income taxes or $185,121 net inheritance.
Robert also wanted to make certain his son Steve didn't blow his inherited IRA, so in his beneficiary designation form he provided the stipulation that Robert could only receive the inherited IRA through the Stretch distribution method, which in this example would hypothetically begin at age 64 with a payment of $13,064 in the first year with total payouts of $527,979 until his life expectancy at age 85. Any unused balance would go to Steve's designated beneficiary.
By properly exercising the Stretch options a total payout of $1,808,827 is received instead of $1,357,884. Furthermore, the original IRA owner's wishes are clear and concise, with no second guessing and full control exercised for multiple generations.
Most Custodians Do Not Perform Stretch IRA Duties
The problem with the Stretch concept is that most IRA custodians, and virtually all 401k custodians do not want to participate in multi-generational IRA distributions. It requires the ability to spread IRA distributions to a multitude of potential beneficiaries throughout their lifetimes. This distribution begins with a unique beneficiary form that makes certain your "qualified" accounts are stretched to all your non-spousal beneficiaries.
An ideal "qualified" retirement account custodian must:
- Guarantee the principal
- Guarantee a minimum rate of return
- Administer the distribution of all beneficiaries at no cost
- Provide binding beneficiary language to make certain you control the distribution well beyond your lifetime
- Periodically review and revise your beneficiary designation form when needed
Today in reality only a handful of life insurance companies have mastered the art of proper "qualified" retirement account multi-generation distribution and accountability based on the new laws and provisions. These companies not only offer an easy to complete binding beneficiary form that will logically distribute your IRA the way you want for multiple generations, but will also guarantee a minimum return of 3% to 6%, guaranteeing your RMDs do not deplete your account, insuring your heirs or charities an inheritance.
Your retirement account beneficiary form is the single most important document in your estate plan because it guarantees that the person you name as the beneficiary of what may be the single largest asset you own - your retirement savings - will actually inherit that asset when you are gone.
Another Example Might Be Helpful:
Doug Wilson, is 70, and will need to begin taking his Required Minimum Distribution at the end of the year. The current value of his IRA is $500,000. At the end of the first year his RMD is $18,248. His account is guaranteed to increase by 5% per year. Even after the RMD in the first year, his account value would have grown to $506,752.
His RMD for subsequent years will be:
- Year 2 - $19,123
- Year 3 - $20,038
- Year 4 - $20,995
- Year 5 - $21,996
- Year 6 - $23,043
On his 75th birthday Doug dies. The total of his RMDs for the six years of withdrawal would have been $123,443. Because his account was guaranteed to grow faster than it was being depleted, his remaining account balance will be $531,033 the day he passes on.
He was a widower and had listed his only child Matthew, (age 54 when his dad dies), as the beneficiary of his IRA. Before he met with us his IRA custodian was Schwab and they made it clear that the only way Matthew could receive the inherited IRA was in a lump sum, or $531,033. Doug's total estate was under the estate tax exclusion ($2 million for 2007-2008), so no estate taxes were due. Because Matthew was scheduled to receive the lump sum, his tax bracket would have jumped to the highest possible and a federal income tax of $185,851 would be due April 15, the year following the year he received the inherited IRA. Matthew would also be required to pay state income taxes ranging from 0% to 11% depending on the state of domicile. The net inheritance for Matthew would have been $345,171 or less.
After meeting with us, Doug transferred his IRA into a 5% guaranteed annuity that provides comprehensive Stretch IRA language in the beneficiary designation form. On the form Doug states that Matthew can choose to either receive the IRA account balance in a lump sum, over 5 years or based on Matthew's RMD calculations for the rest of his life. Matthew would have the ability to accelerate his distributions at any time, but Doug wanted to make certain Matthew had the choice to spread the income over his life, thus spreading the income tax, or pay the tax all upfront.
One important point to note is that, had Matthew been a spend thrift, or a wayward child, through the beneficiary form, Doug could have put specific qualifications in place to control the distribution. He could have done the same had there been any other beneficiaries. The main idea behind the Stretch IRA concept is that it provides options. Most custodians do not want options. Only insurance companies have the ability to truly stretch out the distribution of the IRA funds to multiple beneficiaries and multiple generations.
Had Doug's son Matthew taken the RMD throughout his lifetime, the total before tax payout, (assuming 5% interest each year and a life expectancy of 84, based on the IRS tables), would have been $1,279,153. Of course each year he would have to pay income taxes on his RMD, but most likely, the RMD income would not throw him into the top bracket each year. In the 10th year his RMD would be $27,000, in the 20th it would have grown to $46,146.
Rather than receiving a net payout of $345,171 Matthew will now receive a gross payout of $1,279,153, or 4 times more!
Who Should Consider A "Stretch IRA"?
- If you currently are not withdrawing more than your RMD from your "qualified" account.
- If you have multiple beneficiaries with different needs and personalities.
- If someone other than your spouse will possibly inherit any of your "qualified" retirement plan.
- If you want to control distributions to multiple generations.
- If you want to spread the income over multiple generations.
- If you want to spread the income tax over multiple generations.
Action Items:
- Make certain your IRA/401k custodian allows for the "Stretch Option" for your non-spousal beneficiaries, which includes any contingent or secondary beneficiaries.
- Make certain your IRA/401k custodian allows you continuous multi-generational distribution control of any retirement funds your non-spousal heirs could inherit.
- Make certain you have your IRA/401k beneficiary designation form reviewed by a qualified Retirement Exit Specialist.
- Make certain you receive and review a personalized "IRA Stretch" analysis.
Other Points To Consider:
- IRA owners seldom review their beneficiary designation form. In fact, most couldn't locate it if they were asked to.
- For your beneficiaries to get the Stretch IRA option, you must see if your custodial agreement allows stretch distributions - and then make sure you have correctly designated your beneficiary(ies) on your beneficiary form. If your custodian is reluctant to assist you, you need to switch custodians.
- Most custodians like Schwab, T. Rowe Price, etc. do not want to perform the duties multi-generational Stretch IRAs require.
- Few people understand the new regulations drafted in the 2006 Pension Protection Act about non-spousal IRA rollovers.
- Most people think that they can't control non-spousal IRA distributions after they pass away. They believe everyone has to be treated the same. Not true, with the robust new beneficiary forms a trust isn't required and can be as specific and controlling as you want for as long as the money lasts.
- If you are not a surviving spouse, it is not possible to rollover a deceased person's IRA into an existing IRA account. It must be a separate and new IRA account with the funds being transferred from trustee to trustee. No money can touch the IRA beneficiary's hands.
- In the case of 401k's, most custodians are set up to cash out or pay out not transfer inherited funds. That's fine when the spouse is the beneficiary, but for non-spousal beneficiaries that can be a disaster. If your custodian isn't willing or able to perform Stretch IRA/401k duties you should transfer your account to a custodian that will.
- If you want income guaranteed to you and your beneficiaries, you cannot get guaranteed income from a non-guaranteed account. Today there are accounts that have huge upside growth potential with full guarantees ranging from 3% to 6%.
Additional Resources: Your Complete Retirement Planning Road Map, Ed Slott, 2007 Random House, Estate Planning Made Easy, David T. Phillips, 2007 Kaplan, www.ipers.org/sub/calc/retiredistrib.html, www.epmez.com |
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