The Secret Stretch IRA

It may seem like a contradiction, but there is a way to leave a lot of money to your heirs even if you’re not rich. Individual retirement accounts (IRAs) were established to let you save tax-deferred until age 70 1/2, after which you were required by law to begin withdrawing funds. But new rules define how you can pass on your wealth for two generations and reduce the amount you must take out. Called a stretch IRA, this new version has become a popular estate-planning tool.

“Stretch” is a bit complicated, but at its heart is the miracle of compounding. Over the course of 60 years, assuming an 8% rate of return, $200,000 in an IRA can pay out more than $4.9 million, according to Putnam Investments.

Here’s one way a stretch IRAcould work: A father names his son as a beneficiary. When the father reaches age 70 1/2, he elects to have the benefits stretched over his life and his son’s life. When he dies, the son gets the IRA and can take the money out slowly by spreading withdrawals over his remaining life expectancy. He has to pay income taxes only on the amount he withdraws every year. That’s a huge tax benefit considering that if the father died without naming a beneficiary, the IRA would be liquidated and more than a third could be eaten up by taxes. Spreading the payments out over more time and thus reducing the withdrawals means the beneficiary won’t have to take such a big tax hit right away. The son can also name his own beneficiary, perhaps his daughter, and spread the remaining proceeds to a third generation (although that’s where it stops). Talk about the gift that keeps on giving. “It could grow exponentially,” says financial planner Lee Rosenberg of ARS Financial Services in Jericho, N.Y.

Even though the IRS offers these provisions, some financial institutions won’t let you stretch out your IRA. So before you open an account or decide to keep the IRA where it is, make sure your firm will allow it. If so, designate the beneficiary before you are required to start taking distributions. And keep the paperwork in a safe place. “People lose their IRA assets after death because they can’t find the documents. If you can’t find your beneficiary forms, the firm may treat it as if you don’t have a beneficiary,” says Ed Slott, a Rockville Centre, N.Y., accountant and editor of Ed Slott’s IRA Advisor.

Another problem: you or your parents may have already hit the age that requires you to start taking IRA benefits, which is generally April 1 of the year following the year you turn 70 1/2. Right now, if you missed the deadline, you’re out of luck. But there’s legislation working its way through Congress that would give everyone a chance to start anew. If enacted, the fresh-start rule would go into effect on Jan. 1, 2002.

Keeping track of all these provisions can be confusing, and there are serious tax implications. So you might want to seek the advice of a retirement planner to determine if the stretch IRA works for you. It may not make sense if you’re planning to live off your IRA assets in retirement. But if you have a sizable nest egg, taking the stretch can be a valuable option for you and your heirs. You can’t take it with you, so you might as well leave as much as you can.