[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.
Inherited Stretch IRA
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.
Should You Use a Stretch IRA?
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.
$9 billion dollars?! Wow.
That is better than the lottery jackpot this week.
Of course, $9 Billion in a few decades isn’t the same as $9 Billion now.
If a minor inherits a Roth IRA and is required to take RMD, is the withdraw tax free or would the “kiddie tax” override/apply and become taxed at the parents marginal rate? Would this money be withdrawn into a UTMA/UGMA account and not taxed at the parents rate? Also, can you confirm the requirements that a Roth IRA has to be held for 5 years before making withdrawals in order to take advantage of the benefits? I am working on some estate planning, and just trying to think through some of these issues/constraints and was wondering if you had any advice.
Nope, tax free.
There are two Roth IRA 5 year rules:
https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/
In order to transfer the Roth IRA and receive the stretch benefits for a minor, what is the best method to achieve this: beneficiary designation, will, trust, or other? I would like to include instructions on how to handle this from the beneficiaries perspective, and I guess I am not really sure how this transfer would take place, and what information they or the guardian/fiduciary would need to know.
Beneficiary would be fine and probably best.
Is there anything to stop families from gifting money to older generations so they don’t spend there IRAs and pass them along to younger generations?
Not as long as you stay within gift limits. But I see little sense in doing that unless they need more than their RMDs. Those have to come out of the account anyway.
Not Roths though right?
Roth IRAs have no RMDs.
Sorry, what I was trying to say is that it would seem to make sense for younger generations to convince older generations with Roths to allow them to gift (under gift limits) to support these older generations “in exchange” for keeping the Roth in the family to continue to accrue tax free growth. Essentially, younger generations would always be better off gifting money to buy down a parents Roth that the parent was planning on using rather than investing in taxable accounts if that were the best investment available to the younger generation and they were looking for more. For that matter it would even be better to gift money to older generations for them to do taxable investments that would then have step up basis back to the younger generation upon inheritance. Just wondering whether people discuss such family wealth building strategies or whether the IRS does anything to stop this. Sorry for the unclear questions previously. I appreciated the reply and hope this is more clear.
Yes, there are lots of ways the generations can work together to build wealth, and steps like you suggest are good examples.
https://www.whitecoatinvestor.com/building-wealth-across-the-generations/
Of course, your example may not be nearly as great if the IRA laws are changed as has been proposed to minimize the ability to stretch them. Nothing illegal about it, but few do it because of lack of education, lack of means, and lack of trust of the other generation.
I love the idea in theory, but requires everyone for multiple generations to be on board and be as financially savvy as their ancestors. Haven’t seen too many billionaires today that got that way from just inheriting Roth IRAs.
Reminds of what people think being a doctor is like: On TV, doctors always have freshly pressed white coats with no stains, they appear to be in no hurry at all ever and just effortlessly make $500,000 per year.
In reality we are working nonstop, fighting insurance companies to pay us as the next shift of medicaid patients rolls in.
So in reality, at some point during this fantasy of leaving a Rockefeller like trust to our children, someone will just cash it out, become entitled and lose it in a divorce or some other nonsense.
But again, love the idea of it, I will certainly try it. Can someone please check in on my great-great-great grandchildren to make sure they are financially responsible billionaires?
🙂