Stretch IRA

What Was a Stretch IRA?

A stretch IRA was an estate planning strategy that applied to an individual retirement account (IRA) inherited by a non-spouse beneficiary. By using the stretch strategy, an IRA could be passed on from generation to generation, taking advantage of tax-deferred and/or tax-free growth of the assets within it.

The SECURE Act, part of the spending bills passed by the U.S. Senate on Dec. 19, 2019, and signed into law on Dec. 20 by President Donald Trump, pretty much ended the stretch IRA, and its strategy to shelter inherited income. Under the new law, non-spouse beneficiaries will have to withdraw all the funds in the inherited IRA within 10 years from the death of the original account owner. It applies to IRAs inherited after Dec. 31, 2019.

How a Stretch IRA Worked

The term "stretch IRA" did not represent a specific type of IRA. Rather, it is a financial strategy, used mainly on traditional IRAs, that allowed people to stretch out the life — and thus the tax advantages — of the account. Stretching out an IRA gives the funds in the account more time — potentially decades — to compound tax-deferred. A very young beneficiary could stretch out distributions for decades.

With a traditional IRA, the account owner has to begin taking the required minimum distribution (RMD) by April 1 of the year after turning 72 (another provision of the SECURE Act. It upped the RMD age to 72 — unless a taxpayer was already 70½ or older as of Dec. 31, 2019. In that case, they must start withdrawing funds, as per the old threshold.) The RMD is calculated by taking the account balance on Dec. 31 of the previous year and dividing that number by the number of years left in the owner's life expectancy (as listed in the IRS "Uniform Lifetime" table). Each year, the RMD is calculated by dividing the account balance by the remaining life expectancy.

Under the old rules, non-spousal beneficiaries had to start withdrawing funds from the IRA too — even those who inherited Roth IRAs, which don't carry RMDs for the original account holder. But here was the good part: They could base the RMDs on their own life expectancy. The younger the beneficiary, the lower the annual RMD.

By allowing more funds to remain in the IRA — "stretching" the account over time, in effect — this strategy provided the opportunity to grow the funds significantly for future generations. It also cut the income tax due on the RMD from a traditional IRA (since younger beneficiaries would, presumably, be in a lower tax bracket; even if they weren't, the taxable amount would be much smaller).

In 2016–2017, it was rumored that new legislation would put an end to the stretch IRA and require non-spouse beneficiaries to use a five-year rule for required minimum distributions. But the passage of the Tax Cuts and Jobs Act gave the stretch IRA a reprieve.

Stretch IRAs: Who Used Them

In general, wealthier retirees who knew that their spouse will have enough money for retirement would use a stretch IRA to maintain their family's wealth by naming the youngest person in their family as a beneficiary. Their minimal RMD taxes would mean that the remaining sum in their IRA will continue to grow tax-deferred.

Stretch IRAs were especially beneficial when used with Roth IRAs. As mentioned earlier, inherited Roth IRA beneficiaries — unlike the Roth IRA original owner — were required to take RMDs. But the distributions generally remained tax-free, while traditional IRA distributions are treated as ordinary income.

Special Considerations for the Stretch IRA

It's important to note that the Stretch IRA-killing SECURE Act provision only affects accounts whose owners die after Dec. 31, 2019. For previously inherited accounts, the old rules still apply, and beneficiaries will still be allowed to take distributions over their life-expectancy period. However, investors of all types — both those who have inherited IRAs now and those likely to inherit an IRA in the future — should check carefully with financial or tax advisors to make sure they are in compliance with the new rules.