By Carl Trevison and Stephen Bearce

Stretch IRA Strategy and Your Estate Plan

Most Americans understand an Individual Retirement Account (IRA) can provide a powerful way to save for retirement. But what many don’t know is an IRA can also be an effective estate-planning tool.

If one of your goals is to transfer wealth to your children or grandchildren and leave a financial legacy that could potentially increase over time, the stretch IRA strategy may help you achieve this goal. With some planning on your part – along with educating your beneficiaries on how they need to manage their inheritance – you may be able to turn even relatively small balances into large payouts over time.

The stretch IRA is a strategy, not a special type of IRA. It’s an approach to estate planning that attempts to maximize the tax-advantaged potential of the IRA assets by leaving them in the IRA as long as the law allows. That’s because when a non-spouse beneficiary inherits an IRA, he or she must begin taking required minimum distributions (RMDs) from the IRA in the year following the original owner’s death to take advantage of the stretch IRA strategy.

The term “stretch IRA” refers to the ability of the beneficiary who inherits the IRA to draw out the RMDs over his or her own life expectancy on a “term-certain” basis. “Term-certain” means the assets can’t remain in the account indefinitely; at the end of the “term” the account will be emptied. The younger the beneficiary is, the longer his or her life expectancy – resulting in a smaller RMD as a percentage of the IRA balance. This strategy minimizes how much must be taken out of the IRA each year and, more importantly, allows the funds remaining in the account to potentially continue to grow on a tax-advantaged basis.

To understand how this strategy might work, let’s look at the following hypothetical example. John names his grandson Stephen as the beneficiary of his IRA. John passes away at age 69, and Stephen inherits the IRA with a value of $79,500 at age 21. He begins taking RMDs from the inherited IRA in the year following John’s death. At age 83, assuming Stephen takes only the RMD amount each year, he will have reached the end of his “term-certain” or projected life expectancy and received a total of $866,624 from the Inherited IRA, depleting the account.¹

While Stephen will owe taxes on the pre-tax dollars distributed from the inherited IRA, the impact is a lot less than if he had chosen to take a lump-sum distribution and liquidated the IRA. And, by doing this, he would have foregone the opportunity for the dollars to stay in the IRA and continue to potentially grow on a tax-deferred basis.

In order to make sure the intentions of the stretch IRA strategy are met, the following are some important points for beneficiaries to note.

When a beneficiary inherits the IRA, he or she should direct the firm holding the account to open an Inherited IRA. The Inherited IRA will list the name of the individual who inherited the account as the beneficiary and list the name of the IRA owner as deceased (for example, “Jane Doe, beneficiary, John Smith, deceased). Additionally, the beneficiary must begin taking RMDs by December 31 in the year following the year the IRA owner died. It is important to remember the beneficiary is not the owner of the IRA – that person is deceased. The beneficiary can take distributions and make investment choices, but he or she cannot make contributions to that account.

If you’re considering including your IRA in your estate plan, you can use the stretch IRA strategy with either a Roth IRA or Traditional IRA. It’s important to note that with a Traditional IRA, you have to take RMDs the year you turn 70 ½. Any remaining balance after your death can pass to your beneficiary, and he or she can employ the stretch IRA strategy.

Additionally, you’ll want to give careful consideration to the individual you name as beneficiary. You must list your beneficiary on the IRA beneficiary designation form. You can also name contingent beneficiaries. Since a non-spouse who inherits the IRA will take RMDs based on his or her life expectancy, the younger the beneficiary, the less he or she must take out each year. Therefore, if maximizing the tax-deferred compounding of the IRA is the main goal, a young person is the ideal individual to designate as a beneficiary.

When considering the stretch IRA strategy for your estate plan, keep in mind your needs and tax laws can change over time. The stretch IRA strategy is appropriate for individuals who have other assets to cover expenses in retirement and don’t anticipate needing the funds in his or her IRA to fund retirement.

However, if you’re unsure about whether you’ll need your IRA assets to fund your own retirement, remember that any amount left in the IRA after your death can be stretched by the beneficiary. You can change the beneficiary at any time and you should review beneficiaries at any life event such as a birth of a child or grandchild, marriage, divorce, or death of a beneficiary.

If you have questions about which IRA and estate-planning techniques are right for you, you may want to discuss your options with your Financial Advisor, tax advisor, and attorney.

Our firm is not a legal or tax advisor.

¹ Example is based on a hypothetical projection of the Required Minimum Distribution (RMD) option. The projected values should be reduced for any applicable federal and state income taxes that will be due. All distributions are assumed to be taken at the end of the year. Calculations are based on a 6% annual rate of return and were invested in a Traditional IRA.

This article was written by/for Wells Fargo Advisors and provided courtesy of Carl M. Trevisan, Managing Director-Investments and Stephen M. Bearce, First Vice President- Investments in Alexandria, VA at 800-247-8602.

Investments in securities and insurance products are: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC, Member SIPC, a registered broker-dealer and non-bank affiliate of Wells Fargo & Company.

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