Wednesday, August 4, 2010

Part 1 of 3: The Stretch IRA – Making it Work with a Traditional IRA

What I intend to do over the course of the next few weeks to a month is to explain the concept of the Stretch IRA. In Part 1 I will explain the concept as it relates to a Traditional IRA; in Part 2 I will explain the concept as it relates to a Roth IRA and in Part 3 I will attempt to pull everything together and summarize it all.

Let’s start by first defining “What is a Stretch IRA?” Well, a Stretch IRA is not something that you can physically buy. You can buy a Traditional IRA and you can buy a Roth IRA, but you cannot buy a Stretch IRA. A Stretch IRA is really just a concept or a theory of how an IRA can possibly be Stretched across multiple generations. By understanding the Stretch IRA philosophy and by teaching this philosophy to your family and in turn having them teach their family is a great way to create a legacy for yourself that can affect your future family tree in a tremendously positive way.

In order to explain this concept, I’d like to show you an example of how a family could Stretch an IRA across multiple generations using a Traditional IRA. Then I’d like to explain how possible this can be to implement and I will be backing everything up with the actual numbers that can make this possible.

For Part 1 I will be just showing the concept as it relates to a Traditional IRA, so I’ll give you some basic characteristics of the Traditional IRA, however, if you have any specific questions, for instance, whether you qualify for one, please contact your tax advisor. Here are the most important characteristics of a Traditional IRA:
  • There is a maximum amount that you can contribute to a Traditional IRA per year. In 2010 that amount is $5000.00 or $6000.00 if you were over 50 years old.
  • Contributions made to a Traditional IRA may be tax deductible and the investment grows tax deferrable -- meaning you do not have to pay any taxes until you start withdrawing the money.
  • You may not withdraw any money before you are 59 ½ without a tax penalty.
  • You must start withdrawing the money and cannot make any more contributions to your Traditional IRA after you turn age 70 ½. At this point you must at least withdraw a Required Minimum Distribution (RMD)
    which is calculated by your current age and your life expectancy. Basically, Uncle Sam would like to get all of his tax dollars back before you die!
I know this picture is small and looks complex; however, you can double click on the image to enlarge it and I will be explaining the picture in detail below.

Here’s how the story goes. Granddad Clark invested $91.00 per month, in his Traditional IRA, from age 25 to age 70. By age 70, he accumulated $250,000.00. (By the way, all calculations in this story are based on a very conservative 6% average annual total return.)

Clark had done well for himself and decided he wanted to leave all of the money in his IRA to his heirs. However, since this was a Traditional IRA, at age 70 ½ he had to start withdrawing money down from the account, so he decided to take only the Required Minimum Distribution (RMD) as calculated based on his life expectancy. Clark lived for 10 more years, making $118,897.00 worth of before tax withdrawals and at age 80, Clark died and his wife, Marie, got his Traditional IRA that was still worth $295,106.00.

Marie then made her daughter Amy the beneficiary. Since Marie was over 70 ½, she had to start withdrawing too, and based on her husband's wishes, she decided to only take the RMD that was re-calculated based on her life expectancy. Ten years and $170,766.00 worth of pre tax withdraws later, Marie died, leaving her daughter, still with $308,759.00.

At that point, Amy was age 53, with an IRS life expectancy of 32 more years. (Notice: The originator of the IRA and the spouse are always in the first generation. Amy starts the IRA into the second generation and here is where something different happens. The IRA’s final RMD is now re-calculated to have to be totally emptied out in 32 years based on the life expectancy of the originator of the second generation - Amy.) Over the next 25 years, Amy withdrew $563,158.00 in before tax dollars and upon dying, left her son Michael an additional $296,550.00.

From that, still based on the RMD calculation based on his mother’s life expectancy, Michael was still able to withdraw $372,944.00 in before tax dollars and cleaned out the account over the next 7 years.

This goes to show how a $250,000.00 Traditional IRA could generate a total of $1,225,765.00 in income before taxes and Stretch over a period spanning 52 years and three generations.

If you think this is interesting, be on the lookout for Part 2 where I will show you how you can Stretch a Roth IRA.

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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