How far can you stretch your retirement plan? Estate planners often talk about “stretching” an individual retirement account (IRA) or defined contribution retirement plan, such as a 401(k) plan. In this article I will explain, very briefly, what is meant by the term “stretching.”
In the old days, employees worked for one company most of their lives. When they retired, they received a pension, for example, $800 a month.
Nowadays, companies prefer defined contribution retirement plans. A 401(k), 403(b), and a SEP IRA are all examples of this new breed of retirement plan. The employee, and sometimes the employer, makes contributions to the plan. Compared to defined benefit plans, defined contribution plans leave much more decision-making to the employee.
The employee may or may not choose to make contributions to the plan. In most plans, the employee has some choice as to how his or her assets are invested. With an IRA, the account owner has complete discretion as to the investment of the assets.
There is much less certainty with a defined contribution plan; there is also the opportunity for substantial growth. Yet, probably the most important factor for wealth accumulation that these plans offer is tax-deferred growth. In other words, if you buy Stock X for $10 a share, and five years later you sell Stock X for $20 a share, the $10 in appreciation that you realized on the sale of Stock X will not be taxed.
Let’s assume that if you were taxed on your $10 of realized gain, you would pay $4 in tax. Now you don’t have $20 to invest, you only have $16. If you invest the $16, you will earn less than if you had invested the full $20.
That is the benefit of tax deferred growth. In essence, tax deferred growth allows you to invest your money and Uncle Sam’s money – at least for a little while. The growth is “tax deferred,” because someday, you will have to pay the tax. In the case of these plans, someday is when the account owner begins making withdrawals.
So, one trick to having a retirement plan worth a lot of money is delaying the time when you must take the money out of the plan. With most plans, the owner must take the money out beginning on April 15th of the year after the owner attains the age of 70 ½. In that year, the tax-free party ends, and the owner must beginning taking a portion of the plan every year.
The portion that must be withdrawn is often called the “minimum required distribution amount,” or MRD. Each year’s MRD is based upon the account value and life expectancy factors. For instance, during the owner’s life, in most instances, the owner must take MRD’s every year based upon the combined life expectancy of the account owner and an individual ten years younger than the owner. This combined life expectancy actually produces MRD’s that have a lesser value than if only one person’s life expectancy were used, prolonging the tax deferral.
After the owner of the retirement plan dies, MRD’s can be withdrawn based upon the life expectancy of a “designated beneficiary (DB).” This is where the “stretching” part comes in. A retirement plan is meant to be a retirement plan for the owner.
The government gives the owner tax deferred growth, so that the owner has a nest egg for retirement, but the government wants its money when the person retires. Any technique that will allow the owner to defer the time when taxes are due is a good thing.
By naming a DB, the account owner has paved the way for longer tax deferral. This is because the DB is permitted to take MRD’s over his or her life expectancy after the account owner’s death. So, for example, if the DB were the owner’s 20 year old son, the son could take MRD’s over his life expectancy, which might be 80 years. That’s 80 years of tax deferral. And that’s a big stretch.