Can I Stretch A Roth IRA?

Most of my work centers around retirement planning, so needless to say most of my clients are…well, let’s put it this way, they are approaching that time in their lives when they start getting subscription offers from the AARP and are likely to qualify for senior discounts. But not all of the people with whom I interact professionally are older. If I have the opportunity to help guide the steps of young people financially, I will tell them, from the heart, that they should (a) live within their means, (b) start saving now for their retirement, if they haven’t already begun, and (c) open up a Roth IRA.

“What’s a Roth IRA?” they will sometimes ask. I don’t roll my eyes, but I feel like it. The schools should be teaching this, I think to myself. Maybe it’s because educators think this kind of thing is over the heads of today’s youth. But I can’t understand how some can finish four years of college and not know something as basic to their financial well-being as what a Roth IRA is.

The Roth IRA was named after the late Senator William Roth of Delaware, who was known as a fiscal conservative who hated taxes. He helped engineer the Economic Recovery Tax Act of 1981, also known as the Kemp-Roth Tax Cut. He also led the charge to establish the type of individual retirement account plan that would allow you to pay taxes on the front end of an IRA and withdraw it tax-free on the back end. Why is that important? Let me illustrate it this way:

Suppose you are a farmer. You go into your local feed and seed store to buy your seed for this year’s corn crop. Uncle Sam is there with his top hat. In the hat band of his hat there is a tag that reads, “IRS.” That gives you a clue that he is not there to recruit you into the army; he is there to talk to you about taxes.

“Before you buy that seed,” he says, “I would like to make you a proposition. You can either pay tax on the seed now and be done with it, or I can let you have the seed tax-free. But when it is harvest time and you reap your crop, I will tax you on the harvest. So what’s it going to be?”

“Are you kidding me???” you reply. “I would much rather pay taxes on the seed and not pay any taxes on the harvest!”

As silly as it sounds, that’s exactly what tax deferment amounts to. When we go to work and sink part of our paycheck into a traditional 401(k), for example, we are not paying any income tax on the money contributed. It grows throughout our working years, and then we harvest the money to live on in retirement. We pay taxes on it then.

That arrangement was the only game in town until the Roth IRA became available in 1998. Then in 2006, the other piece of the tax-free retirement account puzzle clicked in – the Roth 401(k) – which is slowly finding its way into corporate America (not all employers offer it yet).

The argument for tax-deferred plans has always been that you build up your account while you’re working, and in a higher tax bracket, and tap into it when your income falls and you are ostensibly in a lower tax bracket. There’s only one hitch to that thinking. We don’t know what taxes will be in the future. But with the national debt clock rolling up trillions of future obligations, all indications are that taxes will be higher, not lower, in the future. But if you do your investing in a Roth IRA, you are dealing with a known quantity. Like all IRAs, taxes are a non-issue as long as the money stays within the account. But there is a huge difference between a Roth IRA and a traditional IRA when you take the money out. You must understand that Roth IRAs are always funded with tax dollars, which means that you won’t get a tax deduction when you contribute to a Roth. But your distributions will be completely tax-free after you’ve had the account for five years, and after you reach age 59 ½.

Suppose you’re 40 years old now. Every year you contribute to a Roth IRA. Over the next 20 years, you might contribute a total of $100,000. With earnings, your account could grow to $150,000, $200,000, or more. Then, because you would be older than 59 ½, you could take out as much as you’d like, year after year. Your neighbors might be paying sky-high tax rates on their income by then, while you’re pulling tax-free dollars from your Roth IRA.

Indexed Investing

Living in sunny Florida as I do, I have little opportunity to walk on ice of any kind. But from all that I have read, the best way to cross ice thinner than four inches thick is to crawl. Crawling across the ice gives you four points of contact instead of two. Your weight is more evenly distributed and there is much less chance of falling through.

Index investing is the same thing in principle. Investing can be a risky business if you put all your eggs in one basket. Spread them out and you even out that risk. Investing via an index within the framework of an fixed index annuity would have beaten the results of having invested directly in the S&P 500 during the past 20 years and would have far outpaced being directly invested in the S&P 500 over the past 10 years. So, if you’re looking for a way to invest inside your Roth IRA, where you want a strong long-term performer, fixed indexed annuities can be an excellent choice. You accomplish three things. You protect your assets from downside market risk, participate in long-term stock market growth, and enjoy tax-free distribution of withdrawals. Some FIA contracts allow you to diversify your Roth IRA investments by tracking indices that reflect large-capitalization U.S. companies (large cap), midsize companies (mid-cap) and smaller companies (small-cap). You may also use an index that follows technical stocks, foreign stocks and others that are linked to commodities, gold prices and real estate.

You might hear or read something that challenges this line of approach, like: “Guaranteed lifetime investments don’t belong in an IRA,” or “Why would you buy a tax-deferred vehicle such as an annuity and put it inside a tax-deferred account such as an IRA?”

Actually, there is a rationale for putting a tax-deferred annuity inside another tax-deferred account. Fixed indexed annuities can offer protection against account losses, since they are immune to the downside risk of the market, and they allow you to withdraw certain amounts, year after year. You simply don’t have those guarantees if you buy common stocks or stock funds for your IRA. Assuming the minimum requirements (five-year holding period, age 59 ½) are met, a Roth IRA becomes a tax-free account. You can invest for decades and eventually extract all the earnings without owing income tax. It simply makes good sense to do as much investing as possible within the shell of a Roth IRA, where your distributions can be tax-free, and invest through an index so your growth will be based on a broader picture of the stock market. It is my opinion that, if you have a Roth IRA, it should be the place of last resort to withdraw money for ordinary living expenses.

Roth IRAs offer yet one more tax advantage. While investors must take at least their required minimum distributions (RMDs) from a traditional IRA, after age 70 ½, Roth IRA owners aren’t required to take RMDs. You can take tax-free withdrawals, if you wish, but if you don’t need the money you can leave your Roth IRA to grow for your beneficiaries, who can then take tax-free withdrawals after they inherit the account.

Stretching Your IRA

In my experience as a financial planner, many people know that an Individual Retirement Account can be a powerful way to save for retirement but few are aware of its effectiveness as an estate-planning tool. It is possible to transfer wealth to future generations while at the same time reducing, deferring or even eliminating income taxes on your retirement savings. The strategy of IRA owners pushing the wealth forward to their children and grandchildren is called “stretching” the IRA. The concept helps you extend the account’s tax-deferred compounding to your heirs. Anyone who has beneficiaries whom they expect will outlive them (a younger spouse, children, grandchildren) can use this strategy. It is not for everyone. But if you don’t need the money in your IRA to make ends meet, then it may be something to consider.

How to Stretch an IRA

The key in stretching an IRA is properly designating your beneficiaries. I am constantly surprised at how little thought some people give to the beneficiaries on their IRAs. Some are not even aware they need to care for this detail. One of the first things a competent financial advisor should do when completing an IRA analysis is to check to see who the designated beneficiary is. On some documents I have seen, the beneficiary line is blank. In other cases where the document has not been updated for several years, the designated beneficiary may be someone who is deceased or a former spouse. If you die, your assets will transfer as you have specified in the IRA document – not according to what’s in your will.

Stretching an IRA can be as simple as naming one or more beneficiaries who are younger than you. You take only the required minimum distributions (RMDs) during your lifetime, leaving the remainder to continue growing tax-deferred while you’re still alive. Most married IRA owners will name their spouse as primary beneficiary and, if they have children, name the children or grandchildren as secondary beneficiaries. Beneficiaries are usually family members, but they can be friends, a family trust or a charitable organization. But if the goal is to preserve wealth for future generations, a stretch IRA will generally allow you to transfer more money to younger beneficiaries when the primary beneficiary dies before the primary beneficiary depletes the account. This allows the other beneficiaries to inherit what is left in the account.

Stretching the Distributions

When you die, your beneficiaries will have some distribution options. What they choose to do may depend on whether they are spousal or non-spousal beneficiaries and whether or not you began taking your RMDs from the account. Keep in mind, each option will have its own tax consequences that will vary according to individual circumstances. For example, the beneficiary may:

  • Take a lump sum
  • Transfer the account balance to an inherited IRA with a five-year          time limit for starting distributions
  • Transfer the account balance to an inherited IRA that distributes assets according to the beneficiary’s life expectancy as shown in the IRS life expectancy table.

If you have heard of IRA owners stretching a $1 Million IRA account to $4 million to future generations over time, it is most likely the last option that has been exercised. While the beneficiary is draining the smallest amount possible from the account, the rest of the money is left to grow at compound interest.

Remember, spousal beneficiaries have the additional option of requesting a spousal transfer, which allows them to roll over the account balance into an IRA in his or her own name.

Stretching a Roth IRA

Can I stretch a Roth IRA? Yes. Check with your financial advisor for details as to eligibility and suitability, but stretching a Roth IRA can be even more effective than stretching a traditional IRA. Roth IRA contributions are not tax-deductible, but your investments grow tax-deferred and earnings can be withdrawn income-tax-free if you’re at least 59½ and have had the Roth at least five years. One of the best things about the Roth IRA is that there are no RMDs at age 70½. Because of these benefits, using a Roth IRA for your stretch IRA strategy may be a smart choice if you have significant IRA balances that you don’t plan to tap during your lifetime. Will the value of a Roth IRA be included in your estate? While the value of a Roth IRA will be included in your estate, the account could grow larger than it otherwise might under traditional IRA distribution rules, potentially leaving more money for your heirs. Another plus is that your beneficiaries will be able to make income-tax-free withdrawals during their lifetimes. The value of this is obvious. It is as if you have prepaid the income tax on their inheritance from your taxable estate by converting traditional IRAs that you did not need into Roth IRAs during your lifetime.

This is a broad brush explanation. Please consult your financial advisor for details as they specifically relate to your estate.

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4 thoughts on “Can I Stretch A Roth IRA?

  1. Yes, you can stretch a Roth IRA. Just make sure you educate your kids about stretching the Roth IRA. They should take the minimum possible based on there birthday!

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