I met with a client the other day who asked me a question that we don’t hear that often, but it does come up occasionally: “What is a stretch IRA and should I open one for my family?”
It’s actually a bit of a misleading question because, if you have an IRA, it has the potential to be a stretch IRA. That’s because a stretch IRA isn’t an IRA in and of itself — it’s a strategy for your IRA.
The stretch IRA can be a lucrative option for passing on generational wealth, but it’s not right for everyone because whether or not the strategy will be used is completely up to your heirs. For some, a life insurance policy held in a trust will help your heirs a lot more than a stretch IRA could.
What Is a Stretch IRA Strategy?
When you have an IRA, you must designate a beneficiary. While some might choose a spouse, others may choose a second-generation heir, like a child or a grandchild. When this is done, the stretch IRA strategy can be used to extend the life of that IRA significantly.
Here’s how it works. You pass away with a remaining balance in your IRA. You have a non-spousal beneficiary assigned to receive the funds. This beneficiary is given two choices. Your beneficiary can take the funds out in a lump sum or in several payments within five years of receipt. Or, he or she can take out an ongoing payment from the account based on his or her own life expectancy. This allows the IRA to stretch beyond one lifetime to another.
The main benefit of this is that the interest that grows on the account will continue to grow on a tax-deferred basis, with taxes only being due on each withdrawal. The younger the individual is when he or she starts receiving these payments, the lower the payment and the longer the account will have to grow. This can turn that IRA from an individual retirement account into a legacy plan designed to support a new generation.
There are still some issues to consider with this, including:
- The IRA must have enough funds to support a second generation’s life of withdrawals.
- Required minimum distributions will still apply, which could significantly deplete the fund.
- Whether or not the beneficiary will take the stretch distribution is up to that individual.
- Not all IRAs allow a stretch strategy to be used.
- The IRA will still be considered part of your estate.
In some cases, this can be a good strategy that can extend the life of an IRA not just to a second generation, but even to a third and fourth generation. It’s a strategy that’s best if you believe your beneficiaries are responsible enough to handle it. Most often, it requires that you’re not entirely dependent on the distributions from the IRA because the goal is to leave enough in the account to let it grow. Ultimately, since it is part of the beneficiary’s taxable estate, it may be appropriate to establish an irrevocable life insurance trust and purchase insurance with some of the distributions from the IRA, which can be gifted to the trust to create a tax-free death benefit outside of the taxable estate to help maximize the legacy that is passed along.
When an ILIT Might Be a Helpful Strategy a with Stretch IRA
Using a trust to hold life insurance policies is another common estate plan that can be used to support future generations. In this strategy, the trust is held outside of the insured’s name, meaning that the largest benefit is that this will not be calculated into estate tax. In addition, life insurance policies pay out tax free, so there won’t be any federal inheritance taxes.
By funding the ILIT with life insurance policies, it’s possible to create a large amount of assets from a much smaller pool of funding. By using stretch IRA distributions, you can create a trust that ultimately benefits not just one beneficiary, but an entire family of them. For more information on using stretch IRA’s and an ILIT to create a legacy plan, contact a Howard Kaye advisor by calling 800-DIE-RICH.
