How to Stretch a Roth IRA to Last More Than 150 Years

I have a philosophy, which is that if you can create win-win situations you should always do so. My daughter, Briana, is 12 years old and has been invited to travel to Europe next summer to be a Student Ambassador through the People to People program (www.studentambassadors.org). One of the requirements I am making for Briana to go is that she must raise one-half of the finds for the trip. Since Briana needs funds for her trip, and my company, Quest Trust Company, Inc. needed help stuffing envelopes to send out our quarterly statements, Briana came to work for us to help stuff envelopes. This earned her money for her trip and at the same time reduced my taxable income – a definite win-win scenario.

You may be asking, “What does this have to do with IRAs?” As her father and as a professional in the area of self-directed IRAs, of course it immediately struck me that Briana now has earned income and is therefore eligible for a Roth IRA, even at age 12. This got me thinking about how long a Roth IRA could last under a certain set of circumstances.

The original owner of a Roth IRA never has to take distributions from that Roth IRA. Briana can therefore accumulate funds in her Roth IRA for her entire life without ever having to take a distribution. This is one of the benefits of a Roth IRA over a traditional IRA. With a traditional IRA distributions must begin no later than April 1 of the year following the year the IRA owner reaches age 70 1/2. When she dies, Briana can leave the Roth IRA to anyone she wants (although she may need her spouse’s consent in certain circumstances if she lives in a community property state). An IRA inherited by someone is sometimes referred to as a “Beneficiary IRA” or a “Stretch IRA,” especially if the person is very young.

Unlike Briana, who never has to take distributions during her lifetime, if a non-spouse beneficiary inherits her Roth IRA they must take required minimum distributions (RMDs) based on the beneficiary’s life expectancy as determined by the IRS. The good news is that if Briana has had a Roth IRA for at least 5 tax years when she dies, required minimum distributions from the inherited Stretch Roth IRA to the beneficiary who inherits the account will be tax free, even if they are under age 59 1/2 at the time of the distributions.

So how might this work out in Briana’s situation? Let’s assume Briana makes exactly $1,000 in earned income for tax year 2008. Roth IRA contributions can be made based on the amount of her earned income (her investment income, if any, doesn’t count), up to a maximum of $5,000 for people under age 50 by the end of the year for 2008. In Briana’s case, since she earned less than the $5,000 contribution limit, she can only contribute $1,000.

If we assume that Briana will live to age 87, and she never makes another contribution to that Roth IRA, the value of the Roth IRA upon her death (75 years from the start of the Roth IRA) would be as follows:

Initial Contribution     Annualized Yield        Result After 75 Years

$1,000                                 6%                  $         89,013.00

$1,000                                12%                 $    7,748,834.00

$1,000                                18%                 $659,839,065.00

For purposes of our discussion, I will assume an annualized yield of 12%. Some may argue that this isn’t realistic, but in fact at Quest we see much higher yields in self-directed IRAs than just 12%. For example, my Mom’s self-directed IRA has achieved a yield of more than 13% per year over the last couple of years by simply doing hard money lending (but that is the topic of a different article). If your calculator holds enough numbers, multiply the appropriate amount from the above chart times 5 or 6 for a full single year contribution depending on the age of the contributor (ie. $5,000 for those under age 50, and $6,000 for those age 50 or older). Of course the results on the chart above do not even account for continuous contributions during Briana’s lifetime, which she will almost certainly make based on the financial education she is going to get from me!

If Briana has a daughter at age 31 (although how she is going to have a child before she’s ever allowed to date I’m not sure), and her daughter delivers her granddaughter at age 31, who in turn gives birth to her great granddaughter at age 31, Briana will be age 81 when her great granddaughter is born (we’ll call her Samantha). If Briana updates her beneficiary designation to leave Samantha her huge Roth IRA, Samantha will be age 6 when Briana dies at age 87. By December 31 of the following year, when Samantha is age 7, required minimum distributions must begin from the inherited Stretch Roth IRA.

To calculate Samantha’s required minimum distributions, her life expectancy must be determined from the IRS Single Life Expectancy Table (Table 1 in the back of IRS Publication 590). Once the appropriate Life Expectancy Factor is found on the table, Samantha must take the value of the account as of December 31 of the prior year and divide it by the factor. For a beneficiary who must begin distributions from an inherited IRA at age 7 the Life Expectancy Factor from the IRS table is 75.8. Samantha’s first year distribution is calculated as follows:

Prior Year End Balance ($7,748,834)

Life Expectancy Factor (75.8) = Required Minimum Distribution ($102,227.36)

In subsequent years the factor is reduced by 1, and in each year the balance on December 31 of the prior year is divided by the new factor (ie. the Life Expectancy Factor is 74.8 in year 2, 73.8 in year 3, etc.). Since the original Life Expectancy Factor was 75.8, after a total of 76 years the inherited Stretch Roth IRA must be completely distributed, either to Samantha or to Samantha’s heirs if she doesn’t live that long.

The best part is that Samantha is not required to just let the money sit there earning nothing for the 76 years of required minimum distributions. As long as there is sufficient funds in the account to meet the annual required minimum distributions, the account can continue to be invested in real estate, notes, private company stock and limited partnerships, among many other choices, so that it continues to grow. In Samantha’s inherited Stretch Roth IRA, for example, during the first year of distributions if the account earns a 12% annualized yield, the income will be $929,860, while Samantha’s required minimum distribution would only be $102,227, resulting in an increase in the account balance of $827,633.

The following chart shows how powerful an inherited Stretch Roth IRA of just $100,000 can be if distributed over a long period of time:

Starting Principal        Beginning Life Expectancy Factor     Yield   Total Distributions

$100,000.00                                     75.8                               6%     $       2,033,743

$100,000.00                                     75.8                             12%    $     80,496,367

$100,000.00                                     75.8                             18%    $3,420,454,810

If an annualized yield of 12% can be maintained for the entire life of Briana and Samantha so that the beginning balance of Samantha’s inherited Stretch Roth IRA is $7,748,834.00, total distributions from the account for Samantha and her heirs would be a staggering $6,237,497,033 – and under current law it is all TAX FREE! This is obviously an incredible estate planning tool. A lifetime of tax free income is quite a gift to leave to your heirs.

It should be noted that I have ignored for the purposes of this article the estate tax and generation skipping tax issues in order to illustrate the power of an inherited Stretch Roth IRA. No one can predict what tax law changes will take place over the next 75 years, or what the estate tax and generation skipping tax limitations will be if they continue to exist for that long. However, you should never avoid estate and tax planning simply because the law might change. We can only plan based on what we know right now. One thing is for sure – to fail to plan is to plan to fail.

H. Quincy Longis an attorney who holds the designation of Certified IRA Services Professional (CISP) and is President of Quest Trust Company, Inc., a third party administrator of self-directed IRAs serving clients in the State of Texas and throughout the nation with offices in Houston and Dallas.  He may be reached by email at Quincy@QuestTrust.com.  Nothing in this article is intended as tax, legal or investment advice.