Everyone has different goals when it comes to leaving money for their heirs. For example, the White Coat Investor aims to give money to his kids in their 20’s and during college while a lot of what is left at the end will go to charities. Others decide to leave money at the end that will be available to their children (or grandchildren) at an older age.
In this vein, many have asked me why I favor a Roth contribution instead of a standard (pre-tax) contribution in my 403B. One of the bigger reasons is the benefit of a stretch IRA (via Roth), or a Stretch Roth IRA. Today, we are going to dive a little more into that topic and see what it’s all about, and if its right for you.
Unlike standard contributions to your 401K/403B, Roth contributions are made post-tax. This has some benefits. Namely, tax-free growth and it is also tax-free when you remove it. A Roth decision is a decision to pay the tax up-front. Additionally, there are no required minimum distributions when you turn 70.5 years old (unlike pre-tax contributions, which do have an RMD).
When you retire, you have three main choices for your Roth 401K/403B that depend on your employer, the IRS, and what you want to do.
- You can leave it where it is and let it grow until you must start taking money out.
- You can start receiving distributions.
- The third option is best: You can roll it over to an IRA (must be done within 60 days of retirement to avoid paying taxes). This makes an inheritance much less complicated for those that receive your money.
So, what is a Stretch Roth IRA?
A stretch Roth IRA is an IRA that you give as an inheritance to someone. This provides some seriously awesome benefits that a standard (pre-tax) IRA does not. Let’s walk through them and then discuss some math to show how cool it is for those inheriting this money.
First, remember that the tax has already been paid prior to putting that money in via a Roth mechanism. Therefore, your heirs will not have to pay tax on it when it grows. This remains true for when they take it out, too. It’s tax-free. Pretty cool.
There is an important difference for your heirs, though. While RMD’s do not apply to you (or to your spouse if they inherit it), it does apply to any others inheriting your IRA. This is determined by the life expectancy of the beneficiary inheriting the Roth IRA. The younger they are, the lower the RMD. Regardless of age, they must take an RMD.
This sounds like a bad thing, but imagine it from the standpoint of the person receiving this money. Every month they would be given an RMD payment to use as monthly income. This income would not increase their tax burden (it’s tax-free). The rest of the money would continue to grow (tax-free). Pretty awesome, if you ask me.
That heir could take that monthly money and use it for expenses or to allow them to invest, which they would be doing because you taught them about money. Wealth that begets wealth.
Facts you need to know
Before we get to some helpful examples below of what this might look like, we need to discuss some facts that you must know in order to take part in a Stretch IRA.
Fact 1: The person receiving the inheritance must make the decision to stretch out the IRA by December of the year AFTER the person they inherited it from dies. If you don’t elect to do this, you will be forced to take out all of the money out in the five year’s after the original owner’s death.
Fact 2a: While RMD’s must occur the year after which the deceased die, the amount of the RMD is determined by the beneficiary’s age. The younger the beneficiary of the stretch IRA, the lower the RMD. This leaves more money to grow for a longer time.
Fact 2b: If you name multiple beneficiaries, then the eldest age of the multiple beneficiaries will be chosen to determine RMD’s. This makes the RMD’s higher, depletes the account faster, and the money has less time to grow. Separating the multiple recipients at the time they are given is key.
I find examples to be helpful. So, let’s think through a few here:
Example 1: The grandpa on Roth FIRE
Let’s say that you decide to achieve FIRE (Financial Independence and Retire Early) at the age of 50. Your 28 year old daughter just had a baby girl who is age 0. Five years later, you and your wife face an unexpected early demise in a car accident. (Morbid, but this post is about inheritance money).
You decided to convert your 401k to an IRA when you left your employer and designated your granddaughter (now she is 5 years old) as the beneficiary, because she is the youngest grandchild in the family. You had $2 million dollars in this account. Under this assumption, the money will continue to grow at 6%.
This is how it works out for the granddaughter.
She would be required to start taking an RMD based on age 6, which would be a little more than $27,000 that year. Remember, that’s tax-free because grandpa already paid the tax. If she doesn’t take out any more than the RMD each year, it will grow to a max of $16,500,000 (16.5 million dollars) by age 66. At that peak, her RMD will be approximately $1,000,000…still tax-free.
Hopefully, she will be investing the majority of that and it’ll continue on for the next grand-kid in the family.
The standard retirement grandpa
Maybe those numbers seem astronomically high. For others in a very different situation, let’s include a more typical situation.
Let’s say that grandpa worked til age 65, and didn’t know as much about personal finances. Or let’s say he worked a modest job that was not high-earning. This grandpa retires, and again he dies 5 years later at age 70. The inherited IRA he is giving his 30 year old granddaughter is worth $500,000. This was, again, Roth money.
In this example, the first RMD at age 31 will be a tax-free $40,000. The account will peak at $5,780,000 (5.78 million) when the granddaughter becomes the age of 66. Her RMD that year will be around $330,000.
That’s still a ton of money. Like “you don’t have to work” money. From only $500,000 of Roth money. If you saved $6,000 per year via a Roth mechanism that would turn into $500,000 in 30 years (if your average gain was 6%). That seems pretty do-able even for lower income earners.
This is another reason that you should “touch your Roth money last” in retirement.
Despite leaving only $500,000 in that second example, the inheritance still provides unimaginable money. And yet none of it raises the taxes of the granddaughters. It is provided as tax-free income to be spent or invested. And it all continues to grow tax-free via the Stretch IRA.
I’d love to hear other thoughts on this. It’s a great big topic, and certainly important. Do you plan to leave money to your heirs? Spending every dime? Giving it away to charities? Some combination? Let us know below in the comments.