Stretch Out Your IRA the Right Way

Good News: This tax benefit can be employed whether or not you rollover your traditional IRA to a Roth IRA.

Many people want to know if it is necessary to convert their traditional IRA to a Roth account to procure a Stretch IRA. The simple answer is NO. However, this reality may have a profound impact on numerous deliberations about Roth conversions and many of the well-informed individuals may find themselves puzzled about this revelation.

It’s vital for you to note that the term “stretch” is not constrained to a specific kind of IRA, but instead, it is a financial tactic to lengthen or stretch out the life – as well as the tax benefits – of an Individual Retirement Account.

Prior to the creation of Roth IRAs by the Congress, the term “stretch” was utilized to denote the method in which a child or grandchild, or a spouse, inherits a traditional IRA and then make withdrawals throughout his or own life expectancy. If the life expectancy is longer, the percentage of the payout based on the IRA balance is smaller.

With a traditional IRA, the funds are taxed as they are obtained straight from the IRA wrapper, whether by the beneficiaries or the account owner. Thus, stretching out the Individual Retirement Account provides funds additional years – even decades – to grow and compound tax-deferred, which is without doubt a wonderful investment option.

With the advent of the Roth, together with the opportunity to perform Roth conversions by all taxpayers regardless of income levels, additional ways for owners of IRA to stretch out tax advantages both for themselves and their beneficiaries are also granted. However, these new policies come with more confusion.

The following are some steps you can take to maximize your tax savings:

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IRA Owner – What to Do

As a traditional IRA owner, you must begin distributing your funds by the 1st of April of the year after you became 70.5 years of age. Gauging the RMD or required minimum distribution is typically a straightforward process. You get the account balance on 31st of December of the preceding year and divide such by the number of years that are left in your life expectancy, as stipulated in the IRS’ “Uniform Lifetime” table.

For instance, If Sam, a widow, will turn 75 years old by 2010 and the balance in your account at the end of the previous year was $100,000, the required minimum distribution for this year amounts to $100,000 divided by the number of years left in her life expectancy of 22.9 – (based from the IRA table), or exactly $4,366.81. Every year Sam is necessitated to distribute her funds, computed in the same manner. However, if Sam remarries and her husband is younger by her by 10 years or more, and her husband was the only beneficiary of her IRA, she can utilize the life expectancy table known as “Joint Life and Last Survivor Expectancy” instead, and Sam’s RMD every year will be smaller.

The confusion takes place here. In a Roth conversion, you shift money from your traditional IRA to a Roth IRA, recompensing regular income taxes (most likely with non-IRA funds) on the amount of funds that you move. You don’t need to obtain annual minimum withdrawals from the Roth account, and future gain in it is free from tax. This delineates that except if you need to distribute the money to cover your expenses, the funds that will be left for the beneficiaries or heirs benefit from the stretch out.

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Therefore, through Roth conversion, you can allocate larger amount of money in your IRA to your heirs, which is tax-free, instead of tax-deferred. This is the same reason why you have been feeling and hearing about the Roth conversion craze and their benefits to those wealthy enough people who wish to leave their retirement plans to their heirs.

Another factor that impacts the stretch retirement account value is the beneficiary that you have chosen. Your elected inheritor must be placed on the beneficiary designation form upon opening the account. You can make changes to this form later. Keep in mind that the money in your IRA will be withdrawn according to this form, and not based on your will.

On the other hand, non-spousal heirs, despite of their age and IRA type, should take RMDs; converting to Roth eradicates RMDs for you, but not to your beneficiaries. The RMDs will be based on the life expectancy of your heirs. As per the IRA tax rules, the younger the beneficiary, the lower the amount of money the beneficiary must withdraw annually. So, if your chief objective is to maximize the stretch-out option, the best candidate to act as your beneficiary is somebody who’s young.

You must not name your estate as your sole beneficiary, because if you do, under the worst events, your money might have to be distributed within five years of your death. If you have a traditional IRA, your account’s income tax should be recompensed as the money is being withdrawn from the IRA. This may also take place if you fail to name a beneficiary, or if the beneficiary designation form can’t be found when it is needed. Contingent beneficiaries should also be named.

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Beneficiaries – What to Do

As an IRA owner, you can’t control if your beneficiaries get maximum advantages of the stretching out. All heirs excluding a spouse should start making distributions beginning on the 31st of the year right after they inherit the retirement account. The required distribution amount is calculated in a similar manner used by the original owners, though with the help of a different IRS table acknowledged as the “Single Life Expectancy”.

Spouse – What to Do

Many married people designate their spouse as their IRA beneficiary to secure their loved ones’ personal finance. The husband or wife has the option to move the assets into his or her own IRA. For a traditional account this means that the spouse can delay the RMDs until the time he or she becomes 70.5 years old. If the spouse inherited a Roth, he or she can attain similar effect by just rolling the assets into his or her own name.

It’s best to name your spouse as your main beneficiary while a younger relative as an alternate or younger inheritor. By doing this, at the time of your death, your spouse can inherit your IRA directly or combine it with his or her own IRA, or deny the account. If the last option prevails, the younger beneficiary you designated will receive the longer, stretch-out IRA.

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