[Update 2020: The SECURE Act limited the Stretch IRA to just 10 years.]
The stretch IRA is not really an investing, or even a retirement topic, but more of an estate planning tool. To understand how it works, you have to learn the rules behind inheriting an IRA. When you inherit a typical investment such as shares of a stock or mutual fund held in a typical taxable account, the basis is reset and you can then sell the investment without tax consequences, or keep it as your own and begin to pay taxes as though you had bought it with your own money on the date of death of the person who left it to you.
However, if you inherit an individual retirement arrangement, you have more options. Option one is to cash it out. You can liquidate the investments with no tax consequences inside the account, but if you want to pull the money out of the IRA and spend it (or invest it elsewhere), the tax consequences can be pretty heavy as it is taxed at regular income tax rates. Imagine being left a $400,000 IRA on top of your $200,000 salary. Something close to 1/3 of that IRA would disappear to the taxman instantaneously. That brings us to option two. You don't actually have to pull the money out of the IRA, at least not all at once. Depending on your age, you may have to take out very little each year. The amount is determined by your life expectancy. For example, if you are 30 when you inherit it, your life expectancy (per IRS Pub 590 Appendix C) is 53.3 years. You divide the value of the IRA by your life expectancy to determine your required minimum distribution (RMD) e.g. $400,000/53.3=$7504 you would need to take out this year. Next year, you use the table to determine your life expectancy and again divide the then current value of the IRA by it to determine the RMD. As you can see, the younger you are, the less you are required to take out of the IRA.
In fact, it is quite possible that the IRA could actually be increasing in value for a long time even with just moderate investment returns. This is the idea behind a Stretch IRA. Instead of only being able to enjoy the benefits of tax-protected growth for just 10-40 years, it is possible the tax-protected growth could be streeeeeeetched out for over 150 years. For example, if you earn money at 20 years old and put it in an IRA and then die when you're 100 years old, leaving it to your 2 year old great, great grandson, who then lives to 100 years old, that money would grow without having to pay taxes on dividends or capital gains for 178 years! Obviously, this is a bit of an extreme case, but you can certainly understand how deferring and avoiding taxes for over a century can be beneficial to a pair of investors.
Even better, you can do this with a Roth IRA. In fact, I would much prefer to inherit a Roth IRA as opposed to a traditional one. Not only do you have the same required minimum distribution rules, but as you take them out each year, the proceeds are completely tax free. The taxes were paid by great grandpa 160 years ago. More importantly, the person leaving the IRA behind isn't required to take RMDs between age 70 and his death, so the Roth IRA is larger at the time of inheritance than a traditional IRA would be.
Imagine the wealth you could create by deferring taxes for so long. I wrote about this in my chapter on IRAs in the Bogleheads Guide to Retirement Planning. I repeat the example here:
Imagine an 18 year old man who starts a Roth IRA with $2,000 today. He gets married at age 53 to someone 20 years his junior. He dies at 73 and leaves her his Roth IRA, which she lumps into her own. She dies 40 years later at age 93, and leaves the Roth IRA to her great-grandchild, who is 2 years old at the time of her death. The child begins taking the required minimum distributions, which at that age is just over 1 percent of the balance, much less than the amount the Roht IRA is likely to be growing each year, even after inflation. Assuming the child lives a long, healthy life (let's say age 95) and never withdraws more than the RMD, this IRA will have provided tax-free growth for 188 years, and he will still leave tax-free money for heirs. Assuming a 9 percent return, the original $2,000 would be worth $229,000 at the time of the man's death. When his wife dies, 40 years later, it would be worth $7.2 million. And 93 years later, this same IRA would have provided millions of dollars of distributions to the great-grandchild, who can leave further millions to his heirs. If he is able to invest the original IRA and reinvest the distributions at 8 percent, he could leave behind more than $9 billion. Now that's an estate tax problem.
So what does this mean for you? Well, if you're interested in making somebody very rich, leave them a large Roth IRA when they are very young. How do you do that? First, you need to have a Roth IRA. You ought to start one of these as a resident, and perhaps increase it using “backdoor Roth IRA” contributions during your career. You can even do some Roth IRA conversions to get a Roth IRA. Second, you need to leave the Roth IRA behind at your death. That means you need to spend something else in retirement so the Roth IRA can keep growing. Third, make the beneficiaries of the IRA young. Leave your kids and grandkids something else. Save the Roth IRA for the great grandkids or even great, great grandkids. Last, ensure a legacy of smart financial decision making by beginning with your children now. It won't grow to $9 billion if the kid blows it on hookers and cocaine.