Ken Himmler.com

The term "stretch IRA" has become a popular way to refer to an IRA (either traditional or Roth) with provisions that make it easier to "stretch out" the time that funds can stay in your IRA after your death, even over several generations. It's not a special IRA, and there's nothing dramatic about this "stretch" language. Any IRA can include stretch provisions, but not all do.

Why is "stretching" important?
Earnings in an IRA grow tax deferred. Over time, this tax-deferred growth can help you accumulate significant retirement funds. If you're able to support yourself in retirement without the need to tap into your IRA, you may want to continue this tax-deferred growth for as long as possible. In fact, you may want your heirs to benefit–to the greatest extent possible–from this tax-deferred growth as well.But funds can't stay in your IRA forever. Required minimum distribution (RMD) rules will apply after your death (for traditional IRAs, minimum distributions are also required during your lifetime after you reach age 70½). (Note: The Worker, Retiree and Employer Recovery Act of 2008 waives required minimum distributions for the 2009 calendar year.)

The goal of a stretch IRA is to make sure your beneficiary can take distributions over the maximum period the RMD rules allow. You'll want to check your IRA custodial or trust agreement carefully to make sure that it contains the following important stretch provisions.

Key stretch provision #1
The RMD rules let your beneficiary take distributions from an inherited IRA over a fixed period of time, based on your beneficiary's life expectancy. For example, if your beneficiary is age 20 in the year following your death, he or she can take payments over 63 additional years (special rules apply to spousal beneficiaries).
As you can see, this rule can keep your IRA funds growing tax-deferred for a very long time. But even though the RMD rules allow your beneficiary to "stretch out" payments over his or her life expectancy, your particular IRA may not. For example, your IRA might require your beneficiary to take a lump-sum payment, or receive payments within five years after your death. Make sure your IRA contract lets your beneficiary take payments over his or her life expectancy.

Key stretch provision #2
But what happens if your beneficiary elects to take distributions over his or her life expectancy but dies a few years later, with funds still in the inherited IRA?
This is where the IRA language becomes crucial. If, as is commonly the case, the IRA language doesn't address what happens when your beneficiary dies, then the IRA balance is typically paid to your beneficiary's estate. However, IRA providers are increasingly allowing an original beneficiary to name a successor beneficiary. In this case, if your original beneficiary dies, the successor beneficiary "steps into the shoes" of your original beneficiary and can continue to take required minimum distributions over the original beneficiary's remaining distribution schedule.

What if your IRA doesn't stretch?
You can always transfer your funds to an IRA that contains the desired stretch language. In addition, upon your death, your beneficiary can transfer the IRA funds (in your name) directly to another IRA that has the appropriate language.

And if your spouse is your beneficiary, he or she can also roll over the IRA assets to his or her own IRA, or elect to treat your IRA as his or her own (if your spouse is your sole beneficiary). Because your spouse becomes the owner of your IRA funds, rather than a beneficiary, your spouse won't have to start taking distributions until he or she reaches age 70½. And your spouse can name a new beneficiary to continue receiving payments after your spouse dies.

A word of caution
While you might appreciate the value of tax-deferred growth, your beneficiary might prefer instant gratification. If so, there's little to prevent your beneficiary from simply taking a lump-sum distribution upon inheriting the IRA, rather than "stretching out" distributions over his or her life expectancy. It's possible, though, to name a trust as the beneficiary of your IRA to establish some control over how distributions will be taken after your death. Your financial professional can help you sort through your stretch IRA options.

Stretching your IRA–A case study
Jack dies at age 78 with an IRA worth $500,000. He had named his surviving spouse, 69-year-old Mary, as his sole beneficiary. Mary elects to roll over the funds to her own IRA. Mary names Susan, her 44-year-old daughter, as her beneficiary. At age 70½, Mary begins taking required minimum distributions over a period determined from the Uniform Lifetime Table. (Mary is allowed to recalculate her life expectancy each year.) At age 79, Mary dies and Susan begins taking required distributions over Susan's life expectancy–29.6 years (fixed in the year following Mary's death). Susan names Jon, her 30-year-old son, as her successor beneficiary. Susan dies at age 70 after receiving payments for 16 years, and Jon continues receiving required distributions over Susan's remaining life expectancy (13.6 years). (See assumptions below.)
 

Assumptions:
• The rate of return on the underlying investments is a constant 6%, although the underlying securities in the account may involve risks that cannot be predicted
• All earnings are reinvested, and distributions are taken at year-end
• The projected figures assume that Mary takes the smallest distribution she's allowed to take under IRS rules at the latest possible time without penalty
• The projected figures assume that tax law and IRS rules will remain constant throughout the life of the IRA
• The projected figures do not take inflation into consideration

When it comes to planning for your retirement income, it's easy to overlook some of the common factors that can affect how much you'll have available to spend. If you don't consider how your retirement income can be impacted by investment risk, inflation risk, catastrophic illness or long-term care, and taxes, you may not be able to enjoy the retirement you envision. 

Investment Risk

Different types of investments carry with them different risks. Sound retirement income planning involves understanding these risks and how they can influence your available income in retirement.

Investment or market risk is the risk that fluctuations in the securities market may result in the reduction and/or depletion of the value of your retirement savings. If you need to withdraw from your investments to supplement your retirement income, two important factors in determining how long your investments will last are the amount of the withdrawals you take and the growth and/or earnings your investments experience. You might base the anticipated rate of return of your investments on the presumption that market fluctuations will average out over time, and estimate how long your savings will last based on an anticipated, average rate of return.

Unfortunately, the market doesn't always generate positive returns. Sometimes there are periods lasting for a few years or longer when the market provides negative returns. During these periods, constant withdrawals from your savings combined with prolonged negative market returns can result in the depletion of your savings far sooner than planned.

Reinvestment risk is the risk that proceeds available for reinvestment must be reinvested at an interest rate that's lower than the rate of the instrument that generated the proceeds. This could mean that you have to reinvest at a lower rate of return, or take on additional risk to achieve the same level of return. This type of risk is often associated with fixed interest savings instruments such as bonds or bank certificates of deposit. When the instrument matures, comparable instruments may not be paying the same return or a better return as the matured investment.

Interest rate risk occurs when interest rates rise and the prices of some existing investments drop. For example, during periods of rising interest rates, newer bond issues will likely yield higher coupon rates than older bonds issued during periods of lower interest rates, thus decreasing the market value of the older bonds. You also might see the market value of some stocks and mutual funds drop due to interest rate hikes because some investors will shift their money from these stocks and mutual funds to lower-risk fixed investments paying higher interest rates compared to prior years. 

Inflation risk

Inflation is the risk that the purchasing power of a dollar will decline over time, due to the rising cost of goods and services. If inflation runs at its historical average of about 3%, the purchasing power of a given sum of money will be cut in half in 23 years. If it jumps to 4%, the purchasing power is cut in half in 18 years.

A simple example illustrates the impact of inflation on retirement income. Assuming a consistent annual inflation rate of 3%, and excluding taxes and investment returns in general, if $50,000 satisfies your retirement income needs this year, you'll need $51,500 of income next year to meet the same income needs. In 10 years, you'll need about $67,195 to equal the purchasing power of $50,000 this year. Therefore, to outpace inflation, you should try to have some strategy in place that allows your income stream to grow throughout retirement.

Long-term expenses

Long-term care may be needed when physical or mental disabilities impair your capacity to perform everyday basic tasks. As life expectancies increase, so does the potential need for long-term care. And the cost of care is growing at a rate faster than inflation. (Source: The National Clearinghouse for Long-Term Care Information, 2008)

Paying for long-term care can have a significant impact on retirement income and savings, especially for the healthy spouse. While not everyone needs long-term care during their lives, ignoring the possibility of such care and failing to plan for it can leave you or your spouse with little or no income or savings if such care is needed. Even if you decide to buy long-term care insurance, don't forget to factor the premium cost into your retirement income needs.

The costs of catastrophic care

As the number of employers providing retirement health-care benefits dwindles and the cost of medical care continues to spiral upward, planning for catastrophic health-care costs in retirement is becoming more important. If you recently retired from a job that provided health insurance, you may not fully appreciate how much health care really costs.

Despite the availability of Medicare coverage, you'll likely have to pay for additional health-related expenses out-of-pocket. You may have to pay the rising premium costs of Medicare optional Part B coverage (which helps pay for outpatient services) and/or Part D prescription drug coverage. You may also want to buy supplemental Medigap insurance, which is used to pay Medicare deductibles and co-payments and to provide protection against catastrophic expenses that either exceed Medicare benefits or are not covered by Medicare at all. Otherwise, you may need to cover Medicare deductibles, co-payments, and other costs out-of-pocket. 

Taxes

The effect of taxes on your retirement savings and income is an often overlooked but significant aspect of retirement income planning. Taxes can eat into your income, significantly reducing the amount you have available to spend in retirement.

It's important to understand how your investments are taxed. Some income, like interest, is taxed at ordinary income tax rates. Other income, like long-term capital gains and qualifying dividends, currently benefit from special–generally lower–maximum tax rates. Some specific investments, like certain municipal bonds, generate income that is exempt from federal income tax altogether. You should understand how the income generated by your investments is taxed, so that you can factor the tax into your overall projection.

Taxes can impact your available retirement income, especially if a significant portion of your savings and/or income comes from tax-qualified accounts such as pensions, 401(k)s, and traditional IRAs, since most, if not all, of the income from these accounts is subject to income taxes. Understanding the tax consequences of these investments is vital when making retirement income projections.

Have you planned for these factors?

When planning for your retirement, consider these common factors that can affect your income and savings. While many of these same issues can affect your income during your working years, you may not notice their influence because you're not depending on your savings as a major source of income. However, investment risk, inflation, taxes, and health-related expenses can greatly affect your retirement income.

Mutual funds have been, and continue to be, a good solution for many investors seeking professional money management. But when you buy shares of a mutual fund, your assets are pooled with those of other fund shareholders. You gain professional money management, but the fund's manager certainly can't tailor its portfolio to meet your individual requirements.

For investors who want or need a more customized approach–for example, in order to better manage their tax liability or control individual stock holdings–separately managed accounts (SMAs) have become popular. Historically used by institutional investors and high-net-worth individuals, SMAs are now available to a wider group of investors as an alternative to mutual funds, though SMAs typically still require a higher minimum investment than a mutual fund might.

What is an SMA?

An SMA is a personal investment account that is customized and managed for you by one or more professional money managers. In an SMA, your assets are not commingled with those of other investors. With a mutual fund, you buy and sell shares of the fund. Even though each fund share represents a proportionate ownership of individual securities within the fund, your share of each of those securities is tiny. By contrast, you are the sole owner of each security within your separately managed account. You also can place securities you already own in an SMA; with mutual funds, you can't. As a result, you and your financial professional have more control over management of specific investments in an SMA.

Why is that control important? It increases your ability to coordinate the sale of specific securities with the rest of your overall financial plan.  It was once common for SMA programs to require a minimum of $1 million in investable assets, but today you can find separately managed accounts with minimums as low as $50,000. SMAs' lower minimums, along with a growing appreciation of their unique features, have led to their increasing popularity.

Is an SMA the same thing as a wrap account?

Both wrap accounts and SMAs charge fees based on the size of assets in the account, and the terms often are used interchangeably. However, with a wrap account, your financial professional may serve as the account's money manager, selecting individual securities or mutual funds for your portfolio. With an SMA, your financial professional may rely on a separate money manager (or multiple managers) to handle the day-to-day management of the portfolio or specific components of it. For example, with an SMA, you may be able to have a money manager who specializes in bonds manage that portion of the portfolio, while another manager who specializes in stock handles the equity portion. An SMA must be managed by a registered investment advisor, who may be independent or part of the same firm as your financial professional.

How SMAs trump mutual funds on taxes

Mutual funds have an inherent lack of tax efficiency. When you buy shares of a mutual fund, you automatically get a share of its embedded tax liabilities. By law, mutual funds are required to pay out realized capital gains to all fund holders, regardless of how long you have held its shares.

For example, if you buy shares in a mutual fund right before a distribution date, you may receive a distribution and have to pay capital gains taxes  even though you may have held the fund for only a short amount of time. The lack of tax efficiency can be a greater problem for actively managed mutual funds that buy and sell securities frequently than it is for indexed mutual funds.

Also, some fund investors can find themselves owing income tax on their fund investment, even though the fund may have declined in value during the year. If a fund manager sells some of a fund's holdings at a profit but other holdings drop in value, the fund can have a capital gains distribution even though its overall net asset value is lower.

By contrast, each security held in an SMA has an individual cost basis. That allows you to make specific tax-motivated moves. For example, you can generally request that your manager sell a position with an unrealized loss in order to offset capital gains, thus reducing your income tax liability.

Example: You sold a vacation home at a profit, but do not qualify for any exclusion. As a result, you owe capital gains taxes on that gain. To reduce your tax liability, you instruct your SMA manager to sell part of your position in a stock that has dropped in value. The manager sells enough stock to ensure that the losses on it offset any capital gains taxes you would owe as a result of the real estate sale.

How SMAs compare with mutual funds on trading costs, fees, and performance

Unlike traditional brokerage accounts, which are commission-based, SMA fee structures are asset-based. They typically cover the investment management fee, trading costs, custody, reporting, and financial planning services.

One thing to consider when comparing mutual fund expenses against SMA fees is the "invisible" trading costs incurred by mutual funds. Mutual fund expense ratios cover fund management fees, administrative costs, and other operating expenses. However, they don't cover trading costs, which include brokerage commissions whenever the fund buys or sells securities. Although these trading costs can vary significantly by mutual fund (depending in large part on their annual turnover rates), estimates of these costs range anywhere from .5% to 1%.

Also, mutual funds often carry a certain amount of cash as a cushion in case they experience a wave of redemptions from investors. That cash can act as a drag on performance. If a fund has to sell securities to meet redemption demands, that also can affect its results. Though an SMA involves its own risks and doesn't automatically guarantee you'll have better returns, you don't have to worry about the impact of other investors' actions, because an SMA has no other investors.

Because of the different ways in which fees for mutual funds and separately managed accounts are calculated, it can be challenging to compare those fees. Generally speaking, the larger your account, the more likely you are to benefit from an SMA. Before investing, ask your financial professional to do an "apples to apples" comparison between SMAs and mutual funds, including total fees and trading costs, to determine which is the better deal in terms of overall costs.

How SMAs can be customized for your specific situation

Another important feature of SMAs is their ability to allow you to exclude certain securities. You also can set sector guidelines to avoid investing in a sector you might disapprove of (for example, tobacco or casino stocks). This flexibility allows you to better tailor your asset allocation for your own unique circumstances and desires–key considerations for many investors with concentrated stock positions.

Example: You work for a large company that is a mainstay of most large-cap stock indexes, and you also hold shares in the company as a result of having exercised stock options. You instruct your SMA's manager not to buy your company's stock, to prevent your net worth being too dependent on one company.

However, don't expect to micromanage every single trade, as you might with a traditional brokerage account. Within the guidelines you set, the money manager typically will have discretion to implement strategies that he or she feels will provide the best returns for you. (After all, if you want to make all the decisions yourself, it probably doesn't make sense to hire a professional money manager.) However, you still have a great deal of flexibility to integrate those decisions with the rest of your financial concerns. And you'll always be able to track what has been bought and sold on your behalf.

The bottom line

For investors who place a priority on control and tax efficiency, and have the necessary capital, an SMA program may make a lot of sense. Your financial professional can help you crunch the numbers, look at your overall financial picture, and determine if an SMA might be right for you.

Life insurance has many uses, including income replacement, business continuation, and estate preservation. Long-term care insurance provides financial protection against the potentially high cost of long-term care. If you find yourself in need of both types of insurance, a life insurance policy that combines a death benefit with a long-term care benefit may appeal to you.

Here's how it works

Some life insurance issuers offer life insurance with a long-term care rider available for an additional charge. If you buy this type of policy, you can pay the premium in a single lump sum or by making periodic payments. In any case, the policy provides you with a death benefit that you can also use to pay for long-term care related expenses, should you incur them.

The amount of death benefit and long-term care allowance is based on your age, gender, and health at the time you buy the policy. The appeal of this combination policy lies in the fact that either you'll use the policy to pay for long-term care expenses or your beneficiaries will receive the insurance proceeds at your death. In either case, someone will benefit from the premiums you pay.

Long-term care riders

The long-term care benefit is added to the life insurance policy by either an accelerated benefits rider or an extension of benefits rider.

Accelerated benefits rider–An accelerated benefits rider makes it possible for you to access your death benefit to pay for expenses related to long-term care. The death benefit is reduced by the amount you use for long-term care expenses, plus a service charge. If you need long-term care for a lengthy period of time, the death benefit will eventually be depleted. This same rider also can be used if you have a terminal illness that may require payment of large medical bills. Because accelerating the death benefit can have unfavorable tax consequences, you may want to consult your tax professional before exercising this option.

Example: You pay a single premium of $50,000 for a universal life insurance policy with a long-term care accelerated benefits rider. The policy immediately provides approximately $87,000 in long-term care benefits or $87,000 as a death benefit. If you incur long-term care expenses, the accelerated benefits rider allows you to access a portion, such as 3% ($2,610), of the death benefit amount ($87,000) each month to reimburse you for some or all of your long-term care expenses. Long-term care payments are available until the total death benefit amount ($87,000) is exhausted (about 33.3 months). Whatever you don't use for long-term care will be left to your heirs as a death benefit.

(The hypothetical example is for illustration purposes only and does not reflect actual insurance products or performance. Guarantees are subject to the claims-paying ability of the issuer.)

Extension of benefits rider–An extension of benefits rider increases your long-term care coverage beyond your death benefit. This rider differs from company to company as to its specific application.

Depending on the issuer, the extension of benefits rider either increases the total amount available for long-term care (the death benefit remains the same) or extends the number of months over which long-term care benefits can be paid. In either case, long-term care payments will reduce the available death benefit of the policy. However, some companies still pay a minimum death benefit even if the total of all long-term care payments exceeds the policy's death benefit amount.

Continuing from the previous example, if the policy's extension of benefits rider increases the long-term care benefit (the death benefit–$87,000–remains the same) to three times the death benefit ($261,000), the monthly amount available for long-term care increases to $7,830. On the other hand, if the extension of benefits rider extends the length of time the monthly long-term care benefit is available, then the monthly payments ($2,610) are extended for an additional 24 to 36 months beyond the initial number of months (33.3) available.

Other provisions

Ty pically, qualifying for payments under a long-term care rider is similar to the requirements for most stand-alone long-term care policies. You must be unable to perform some of the activities of daily living (bathing, dressing, eating, getting in or out of a bed or chair, toilet use, or maintaining continence) or suffer from a severe cognitive impairment.

An elimination period may also apply: you pay for the initial cost of long-term care out-of-pocket for a specific number of days (usually 30 to 90) before you can apply for payments under the policy. As with all life and long-term care insurance, the insurance company will require you to answer some health-related questions and submit to a physical examination before issuing a combination policy to you.

Is a combination policy right for you?

Deciding whether a combination policy is right for you depends on a number of factors. Do you need life insurance and long term care insurance? How much life and long-term care insurance will you need? How long will you need it? Will the long term care part of a combination policy provide sufficient coverage?

A long-term care rider may not provide as many features as a stand-alone long-term care policy. For example, the combination policy may not cover assisted living or home health aides. It also may not provide an inflation adjustment, an important feature considering the rising cost of long-term care. The tax benefits offered by a qualified long-term care policy may not apply to the long term care portion of combination policies, which could result in taxation of long-term care benefits received from the policy. 

What if your life insurance needs change as you get older and you find that you no longer want life insurance protection? It's not uncommon for people to drop their life insurance in their later years if there's no compelling need for it, but if you surrender the combination policy, you're also forfeiting the long-term care benefit it provides, usually at a time when you are most likely to need it.

And keep in mind that as you use your long-term care benefits, you're depleting the death benefit–a death benefit you presumably wanted to pass on to your heirs or perhaps use to pay for estate taxes.

Finally, compare costs of combination policies to other forms of life insurance, such as term insurance, and stand-alone long-term care policies. Depending on your age and health, the cost for the combination life policy may actually be higher than the total premiums paid for separate life insurance and long-term care policies, especially if your life insurance need is temporary (such as income replacement during your working years) rather than permanent.