Turning Molehills into Mountains – The Stretch IRA Trust
BY JACOB A. HALE
So you weren’t born a millionaire, huh? Neither was I, but my grand kids might be and so can yours. The IRS—yes, that IRS—has recently made it relatively simple to accomplish. I’m talking about the “Stretch IRA.”
The term probably sounds familiar to you because it has been bandied about over the past decade by any number of financial professionals and its praises have been sung in publications from Time to The Wall Street Journal. But what is it? What does it do? Who is it good for?
Essentially, the “Stretch IRA” or “Multi-Generational IRA” takes advantage of the miracle of compounding to provide us with the greatest generational-wealth building tool available today.
The “Stretch IRA” isn’t a special type of IRA in the way that Roth, SEP or SIMPLE IRAs are. Rather, it is an estate planning concept that attempts to maximize the tax-deferred growth potential of the IRA by leaving its assets in the account for as long as the law allows. In the interest of keeping things interesting, I will limit the discussion of how
a “Stretch IRA” works to an illustration.
Franny and Seymour, both ages 65, have a traditional IRA with a balance of $250,000 earning 8%. During their lifetime, Franny and Seymour take only the Required Minimum Distribution. They have a 45-year-old son, Buddy and a 20-year-old granddaughter, Bessie. Assuming Seymour passes away at 82, and then Franny at 85, Franny and Seymour would have received a total of $355,321 in RMDs from the account and the IRA’s value at Franny’s death will have grown to $585,288.
Let’s say Franny and Seymour designated Buddy (son) and Bessie (granddaughter) as equal beneficiaries of the $585,288 IRA. Buddy, now 65, and Bessie, now 40, have decided to stretch their IRAs. Now, instead of using Franny and Seymour’s life expectancies to determine the RMD, Buddy and Bessie’s can be used. This means that less money will be distributed, allowing the IRA to grow substantially. Over the next 21 years, Buddy will receive $583,114 in total after-tax distributions. Over the next 44 years, Bessie will receive $1,948,520 in total after-tax distributions. Collectively, Buddy and Bessie will have received $2,531,634 after tax.
And what if Buddy and Bessie had just done the natural thing and taken a lump sum distribution of $292,644 a piece and closed the IRA accounts? For starters, they will both pay $89,517 (at a 33% tax rate) when they file their next tax return. Collectively, Buddy and Bessie will receive $406,254 after tax—less than 20% of what they would have received had they simply stretched the IRA.
The effectiveness of the “Stretch IRA” relies on a few initial assumptions. One is that you have other financial resources for retirement and you and your spouse will not need to dip heavily into your IRA in your lifetime. But primarily, the “Stretch IRA” is for those who would prefer to use their IRA to build enormous generational wealth for their heirs.
So how is it done? It might surprise you — and some financial advisors — to know that the IRA won’t stretch itself. Stretching an IRA is not automatic, nor is it likely to be done. IRA beneficiaries almost always make the mistake of withdrawing more than the RMD, thereby losing tax deferral on the withdrawals. Remember that an inherited IRA is very likely the largest pile of liquid assets that beneficiaries will ever encounter.
The answer is a Stretch IRA Trust. The popular revocable living trust will not work here. The Stretch IRA Trust will ensure that RMDs are taken properly and will offer spendthrift protection against young or unwise beneficiaries. And because IRAs are not inherently asset protected, owning the IRA within a trust will help discourage lawsuits, creditors and divorcing spouses. Further, if a beneficiary is receiving Medicaid or other public disability income, the trust can be structured in a way that ensures those benefits continue and that the government will not reimburse itself from the inherited account. In addition to the protections listed above, the trust can also provide for generation-skipping estate tax.
However, the most important feature of a Stretch IRA Trust might be the control it affords the original owner of the account. With a Stretch IRA Trust, the owner can assert complete control over the path the IRA takes down beneficiary row, rather than simply handing it off to the first beneficiary and letting the wind carry it from there (maybe to a new spouse or children from another marriage). With a little self-discipline and foresight, a wealth planning attorney and your financial advisor can help you transform your IRA into a tremendous opportunity for your family.
Download full article (pdf)