What it means
An IRA is a US retirement savings account in which investments grow without annual tax, and the tax is paid when money is withdrawn. When the owner dies, the account passes to the named beneficiaries.
Before the change in law, a beneficiary could often take the inherited account over their own life expectancy, which for a young heir could mean forty years or more of tax-deferred growth. The attraction was compounding (earning returns on past returns).
Each year only a small required minimum withdrawal was taxed, while the large remaining balance stayed invested. Financial planners used it to build family wealth, naming grandchildren as beneficiaries to make the stretch as long as possible.
In 2019 the United States passed the SECURE Act, which replaced the lifetime stretch for most non-spouse beneficiaries with a 10-year rule. Under it, the inherited account generally has to be emptied by the end of the tenth year after the owner's death.
Certain eligible designated beneficiaries, including a surviving spouse, a minor child of the owner, a disabled or chronically ill person, and someone not more than ten years younger than the owner, can still use life-expectancy withdrawals. The shift changes planning.
An heir who must empty an account within ten years may face a larger taxable income during that window, so planners look at spreading withdrawals evenly or timing them for years of lower income. Some owners now convert money to Roth accounts during life, because qualifying withdrawals from a Roth account are generally tax-free.
Because the rules are detailed and have been amended, they should always be checked against current guidance. The beneficiary designation form is also critical, since the account passes according to that form and not according to the will.
Outside the United States the phrase is rarely used, although similar ideas appear in other countries' pension inheritance rules. Anyone living abroad with a US account should take local tax advice as well.
In practice
Real-world examples.
Example
A widow inherits her husband's $600,000 IRA and rolls it into her own account, which lets her delay required withdrawals until her own required age. As a surviving spouse she keeps the greatest flexibility, so the account can keep growing for years.
Example
A 30-year-old inherits a $400,000 IRA from a parent. As an adult child who is not disabled, he must empty the account within ten years. His adviser spreads withdrawals of about $40,000 a year to avoid a single large tax bill.
Example
A retired engineer, aware of the change in law, converts $50,000 a year of his traditional IRA to a Roth IRA during his lower-income years. His heirs will then inherit a pot that can be withdrawn tax-free, even though they must still empty it within ten years.
Formula
Calculation
Required annual withdrawal under a stretch = account balance at the start of the year / life expectancy factor
Suppose a beneficiary who qualifies for a stretch inherits an IRA of $500,000 and the life expectancy factor for the first year is 40. The withdrawal is $500,000 / 40 = $12,500, which is 2.5% of the balance. Under the 10-year rule, by contrast, a beneficiary could take equal withdrawals of $500,000 / 10 = $50,000 a year, ignoring investment growth, or even delay until the tenth year. The annual taxable amount in the first case is only a quarter of that in the second.Case study
Seen in the real world.
Oakridge Family Office is an illustrative, fictional advisory firm that managed a $1,200,000 IRA for a client who had planned to stretch it to his three grandchildren for decades. After the law changed, the plan no longer worked, because the grandchildren would now face the 10-year rule.
The advisers modelled the tax effect. If each grandchild took nothing until year ten and then withdrew a third of the account, each would face a large taxable amount in a single year. Spreading withdrawals evenly across the decade kept each one in a lower bracket.
The client also began converting part of the account to a Roth IRA each year while his own income was modest. The illustrative lesson is that the change of law did not end estate planning, but it pushed planners to think about the timing of tax rather than the length of deferral.
Watch out
Common mistakes.
- Believing every beneficiary can still stretch over a lifetime, when most non-spouse heirs are now limited to the 10-year rule.
- Waiting until the last year of the 10-year period to withdraw everything, which can create a very large single-year tax bill.
- Forgetting that the beneficiary form overrides the will, which can leave the account with an unintended person.
Questions
People also ask.
Is the stretch IRA still allowed?
It is allowed for eligible designated beneficiaries such as a surviving spouse, but most other heirs are now subject to the 10-year rule.
What is the difference between a traditional and a Roth inherited IRA?
Withdrawals from an inherited traditional IRA are generally taxable income, while qualifying withdrawals from an inherited Roth IRA are generally tax-free.
Who decides the life expectancy factor?
It comes from published tax tables issued by the tax authority, which can be updated from time to time.
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