Monday, August 16, 2010

Part 2 of 3: The Stretch IRA – Making it Work with a Roth IRA

Before reading this post I would recommend that you read the following first:
In Part 1 I explained that the Stretch IRA is really just a concept of how you can Stretch an IRA across multiple generations, and I showed an example of how it can work with a Traditional IRA. Now I want to show you the same example, however, this time it will be geared towards making it work with a Roth IRA instead.

So, just like in Part 1, when I gave you some basic characteristics of a Traditional IRA, I want to give you some basic characteristics of a Roth IRA: (The same disclaimers apply here as in Part 1 – if you are interested in getting a Roth IRA, check with your tax advisor first, to make sure you are eligible.)
  • There is a maximum amount that you can contribute to a Roth IRA per year. Just like a Traditional IRA, in 2010 that amount is $5000.00 or $6000.00 if you are over 50 years old.
  • Any contributions made to a Roth IRA are not tax deductible like that of the Traditional IRA; however, the Roth IRA’s investment grows tax free and withdrawals are tax free too.
  • You may withdraw your Roth IRA contributions at any time, however, you must be over 59 ½ to withdraw any growth on the investment without a tax penalty.
  • You are not required to start withdrawing any money from the Roth IRA at age 70 1/2. Likewise, you can still make contributions to your Roth IRA after you turn age 70 1/2.
If the image above is too small, please double click to enlarge it.

Note: This example is assuming a very conservative %6 rate of return – and all of the Roth IRA withdrawals are tax free.

The story starts the same as it did in Part 1: Granddad Clark invested $91.00 per month, in his Traditional IRA, from age 25 to age 70. By age 70, he had accumulated $250,000.00. (Note: There are no age limitations for making contributions to a Roth IRA like there is for a Traditional IRA. In the Traditional IRA example in Part 1, after the age of 70 ½ Clark had to take Required Monthly Distributions (RMDs) and could no longer contribute to the Traditional IRA. With this Roth IRA example Clark is not required to take RMDs and could keep on contributing to his IRA, but for the sake of comparison, no new money will be added to the Roth IRA after age 70 – any additional money added will just be from the growth at 6% rate of return.)

Clark had done well for himself and didn’t need the IRA as his primary source of retirement income so; he decided he wanted to leave all of the money in his IRA to his heirs. Over the next ten years Clark makes no new contributions and takes no withdrawals and at age 80, Clark died and his wife, Marie, got his Roth IRA which grew from $250,000.00 to $447,712.00.

Marie then made her daughter Amy the beneficiary. Ten years later after also not taking any withdrawals and having the Roth IRA grow to $801,784.00, Marie died.

At that point, Amy was age 53, with an IRS life expectancy of 32 more years. (Note: Just like with the Traditional IRA example in Part 1, the originator of the IRA and the spouse are considered the first generation and Amy starts the second generation. One of the basic characteristics of a Roth IRA that I listed earlier that states that you are not required to make withdrawals at a certain age – that only applies to the first generation. Since, in this example, Amy starts the second generation, she will be required to withdraw money based on her life expectancy calculated by the IRS.) Over the next 25 year, by taking only the Required Minimum Distribution (RMD), Amy had to withdraw $1,423,200.00 and still left her son Michael an additional $317,826.00 after she passed away.

From the amount left from his mother, Michael had to continue the withdrawing the RMDs as calculated by his mother’s life expectancy. And he was still able to withdraw $398,496.00 over the next 7 years before the account was emptied out.

So, by starting out with the same amount of money and just using a different investment vehicle – the Roth IRA instead of the Traditional IRA, the differences are astounding. Both examples started out with $250,000.00, but with the money in a Roth IRA, it is possible for $1,821,696.00 in Tax Free income to be Stretched over the same period of time as the Traditional IRA – a period spanning 52 years and three generations.

If you remember from Part 1 with the Traditional IRA, the income stretched over the generations was $1,225,765.00; however those were in before tax dollars, whereas the Roth IRA was totally tax free. The after tax total for the Traditional IRA ended up being $882,551.00, which is good, but, that’s a $939,145.00 difference in favor of the Roth IRA! Don’t you think this is important to know if you were planning on leaving a legacy for your family?

Coming soon - the grande finale - Part 3 of the series where I will wrap up the topic of the Stretch IRA and hopefully tie up any loose ends. See you soon!

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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