For many people, money in individual retirement accounts is their biggest asset. Yet if questions from readers are any indication, it’s also a source of enormous confusion.

One area of befuddlement involves what’s called a “stretch IRA.” Proposals to eliminate this terrific planning tool escaped the Tax Cuts and Jobs Act – the tax overhaul that was enacted in late December. So for now the stretch IRA survives. Here’s what you need to know to take full advantage of it.

A stretch is a strategy. Though the term “stretch IRA” is commonly used, it’s a bit of a misnomer. In this context the word “stretch,” which is short for “stretch-out,” does not refer to a specific type of IRA. Rather, it is a financial strategy that enables someone who inherits an IRA to draw out distributions over his or her own life expectancy. The younger the inheritor, the smaller each payout must be.

With a traditional IRA, the money is taxed as it is taken out of the IRA wrapper, whether by the account owner or heirs (called beneficiaries). Stretching out the IRA gives the funds extra years, and potentially decades, to compound tax-deferred – a wonderful investment opportunity.

Tax-wise, things work differently with a Roth IRA (named for the late Senator William Roth). You generally pay tax when you put money into the account, or when you convert or roll over a traditional account to a Roth. The payoff is that, subject to certain restrictions, no income tax is assessed on distributions by you or your heirs. In other words, all future growth takes place inside a permanently tax-free wrapper. So if the investments explode in value (and/or tax rates rise later), you will have paid off the tax bill for this account at a bargain rate.

Roth is better, but not essential. With a traditional IRA, the owner must start taking withdrawals by April 1 of the year after turning 70½. Calculating this required minimum distribution (RMD) is simple arithmetic. You take the account balance on December 31 of the previous year and divide it by the distribution period that corresponds with your age on the Internal Revenue Service Uniform Lifetime table, which downloads here as a PDF.

If you are married and your spouse is more than 10 years younger, you can use a different table that results in a smaller annual distribution. You can find that Joint Life and Last Survivor Expectancy table, as it’s called, in Appendix B of IRS Publication 590-B, which downloads here.

In a Roth, you don’t have to take yearly minimum distributions from the IRA, and future growth is tax-free. That means unless you withdraw the money to live on, there will be more left in the IRA for your heirs to stretch-out.

You do not need to convert a traditional IRA to a Roth in order to get the stretch-out (a common misconception). But if you convert to a Roth, the IRA you leave behind might be larger because you were not required to take distributions yourself. And the account will grow tax-free, rather than tax-deferred.

Beneficiary forms rule. The beneficiary form on file with the custodian of an IRA controls who inherits it. If people other than a spouse are named as heirs, they must begin taking distributions from the account by December 31 of the year after inheriting. That’s true whether the account is a traditional IRA or a Roth. But beneficiaries can draw these RMDs out over their own expected life spans, enjoying decades of income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA.

To calculate this RMD, you take the balance on December 31 of the previous year and divide it by the beneficiary’s life expectancy, as listed in the IRS’ Single Life Expectancy table, which downloads here as a PDF. Unless the account is a Roth, there is income tax on this required payout.

One thing you should never do is name your estate as the beneficiary – a mistake even smart, highly educated people have made. If you do, and it’s a Roth IRA, all funds must be withdrawn within five years. For a traditional IRA the same rule applies, unless the former owner was already 70½. In that event the distribution rate for the heir is based on the age of the person who died.

Make sure to name contingent beneficiaries as well. If you don’t, and your named beneficiary dies before you, the money will revert to the estate.

IRA trusts have traps. There are pros and cons of naming a trust as the IRA beneficiary, rather than leaving these assets directly to individuals. A trust can protect the IRA assets from creditors – the most common one is a divorcing spouse. You might also consider a trust if you want to control the cash flow to heirs whom you regard as imprudent: In this case the trust can, in effect, force heirs to take advantage of the stretch-out. But a trust adds potential complications and expenses to what can otherwise be a fairly straightforward arrangement.

Plus, there are potential pitfalls. When the trust meets certain requirements set by federal regulations, the IRS will “look through” the trust and treat its beneficiary as if he or she were directly named the IRA’s beneficiary. This enables the trust to take advantage of the stretch-out. In trusts with multiple beneficiaries, the required yearly withdrawal will be based on the life expectancy, under the IRS table, of the oldest beneficiary. If the trust doesn’t qualify as a look-through, or see-through, trust, it will still get the money. However, it may be required to take the payout within as little as five years.

Spouses are special. Most married people name their spouse as beneficiary of an IRA, and the law gives a spousal inheritor special privileges. A spouse – let’s assume it’s the wife – can roll the assets into her own IRA. For a traditional IRA that means she can postpone RMDs until the year after she turns 70½. Or, after rolling over the IRA she can convert it to a Roth and eliminate the need to take withdrawals altogether. If she has inherited a Roth, she can achieve the same effect by simply rolling it into her own name.

You can’t rule from the grave. For better or worse, IRA owners can’t control whether inheritors take maximum advantage of the stretch-out. Though in theory younger beneficiaries stand to reap the most from this strategy, they may have good (or bad) reasons for cashing the money out early: for example, to buy a car, help finance the purchase of a house or pay for a child’s college education. In financial lingo this is called “blowing the stretch-out.” And in real life it happens all the time.

Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide. A free update to the book, reflecting the recent tax overhaul, is available for download on the book’s website. Follow Deborah on Twitter at @djworking and join her on Facebook here. You can subscribe to future blog posts by using the sign-up box on the homepage of her author’s website.


How to Be Richer in Retirement