Is a Stretch IRA Better a Better Choice?

A Stretch IRA Changes Distribution Requirements

Retired couple looking at the water
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A "stretch" IRA gets its nickname literally. It's an inherited individual retirement account whose beneficiary is eligible to "stretch" the required minimum distributions over a longer period of time-based on his own life expectancy. His life expectancy is determined by the applicable IRS life expectancy table. He does not have to use the decedent's life expectancy, which in most cases would be significantly shorter.

Who Is Eligible?

Any individual beneficiary, such as a child, grandchild, niece, nephew or even a friend, is eligible to stretch an inherited IRA. Charitable organizations are not eligible because they do not have life expectancies.

What are Required Minimum Distributions? 

A required minimum distribution, often called an RMD, is an amount that must be withdrawn from certain retirement plans each year according to tax law. The owner of the account cannot leave the account intact indefinitely, allowing it to continue to grow tax-free.

The Internal Revenue Code provides that contributions made to an IRA are tax-deductible, and they're deductible on state tax returns as well. But the IRS wants some revenue out of these accounts, so withdrawals are taxed at the owner's regular income rates. With the exception of Roth IRAs, owners must begin taking taxable withdrawals -- RMDs -- by age 70 1/2 if they've retired.

The IRS imposes some stiff penalties for not doing so. 

When Do Beneficiaries Have to Begin Taking RMDs? 

The beneficiary of an inherited IRAs generally has two options. He can withdraw the entire account within five years of the owner's death, or he can begin taking RMDs based on his own life expectancy within one year of the date of death.

If his life expectancy is much longer than that of the owner, this can result in lower required distributions and less taxable income each year to the beneficiary. 

What Happens If the Beneficiary Doesn't Stretch Out the IRA?

A beneficiary who is eligible to stretch the required minimum distributions over his own life expectancy does not have to do so. He can liquidate the inherited IRA at any time, but this will result in the inclusion of the entirety of the funds in the beneficiary's taxable income for the year in which they were withdrawn. If the beneficiary does not need the money for some pressing reason, it's typically better tax-wise for him to take only the required minimum distribution each year.

Surviving Spouses Have Another Option 

A surviving spouse named as the primary beneficiary of a decedent's IRA has an additional option: She can roll the funds over from the inherited IRA into her own IRA. This allows her to treat the inherited IRA as her own, subject to her own RMD requirements and life expectancy. 

IRA beneficiaries, including surviving spouses, usually have several options to choose from when deciding what to do with the account. The rules for these options can be complicated.

A beneficiary would be wise to consult with an estate planning attorney, a financial adviser or an accountant before making any decisions about how much to withdraw from an inherited IRA.

NOTE: State and federal laws can change frequently and this information may not reflect the most recent changes. Please consult with an attorney or a tax professional for the most up-to-date advice. The information contained in this article is not legal or tax advice and it is not a substitute for legal or tax advice.