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How to Stretch an IRA

Future generations can profit, but many beneficiaries take the money and run

Wouldn't it be great if you could leave a financial legacy to your kids or grandkids that could actually increase over time? Well, you can, with a little bit of planning on your part — and a little educating of your beneficiaries.

See also: Leave an IRA that's heir-tight.

A "stretch" IRA extends its tax advantages like taffy across generations, provided, of course, the account is not depleted.

"If the original owner needs to use all the funds in the IRA, then that's an end to it," says Richard Reyes, a certified financial planner in Maitland, Fla. But if money does pass to a beneficiary, it doesn't have to be taken out in a lump sum, with the attendant big tax hit. It can flow from the account in small increments stretched out over the beneficiary's lifetime, says Reyes. Or even beyond.

The account can be a regular IRA or a Roth. If you are the original owner, all you have to do is name a beneficiary, such as a child or grandchild. It's the beneficiary who does the stretching by following certain guidelines.

There is no benefit to you except maybe knowing that you'll be helping someone after you're gone and helping keep money away from the tax man for a longer period of time.

"A stretch IRA is one of the biggest benefits of the tax code," says Ed Slott, a CPA and author of Parlay Your IRA into a Family Fortune. But, he adds, "it's only good if everybody knows what they're doing."

Next: Stretching an inherited IRA. >>

Stretching an inherited IRA

If you're the person who is willed an IRA, here's what you need to do to make it stretch.

"When you inherit an IRA, the first rule is, touch nothing," says Slott. "If you roll the inherited IRA into your own IRA or even move it to another institution, the money instantly becomes taxable."

As the beneficiary, you must retitle the IRA with your name and the deceased's name. For example, "John Doe IRA (deceased Jan. 1, 2010) for the benefit of John Doe Jr., beneficiary."

You must begin withdrawals of the required minimum distribution (RMD) starting on Dec. 31 of the year after you inherit. They'll be taxable. Their amount is calculated by dividing the IRA's balance by the number of years of your life expectancy as determined by the IRS. The younger you are, the smaller the RMD.

If you want to stretch the IRA to a third generation and potentially make the account bigger, take out only the RMDs and try to invest the remaining principal wisely. As Slott puts it, you have to decide if you want the IRA to grow: "Do you want a little twig or a big tree?" he says.

Not all IRAs stretch

But not every stretch IRA is destined to become a tree. Reyes says that conditions that determine an account's continued growth may change. For example, IRS rules may evolve, returns on principal may vary, or a beneficiary may take out more than the minimum.

"Nine out of 10 beneficiaries want to take the money and run," says Reyes, so "stretching" never gets started.

A stretch IRA "looks good on paper," he says, "but too often doesn't translate into reality."

Cathie Gandel is a freelance writer based in Bridgehampton, N.Y.

Also of interest: Who inherits the cottage by the lake? >>