Last week I shared a little-known secret of how to legally turn an investment of $3500 per year into MILLIONS AND MILLIONS OF DOLLARS. No, it wasn’t by winning the lottery! It was through the power of ‘stretching’ an IRA.

Most people think that when they inherit an IRA that they have to take all the money out and pay taxes on it right away. But the IRS allows someone who has inherited an IRA to ‘stretch’ it over their life expectancy. They are only required to take out a small portion each year, allowing the rest to continue growing within the account.

In the last article a greatly oversimplified example was used because of space constraints. I used the example of Sam making a $3500 per year contribution to his IRA for 30 years until he retired. After retirement, he started to withdraw 5% per year until he passed away at age 80. His 50 year-old daughter inherited it, continued to withdraw 5% per year and let the rest grow for 30 years. Assuming the account earned 10%, it could have grown to over $9,000,000 by the time she passed away.

Technically, the IRS would require Sam’s daughter to withdraw money more quickly from Sam’s IRA. Based on her life expectancy, it would be designed to take the account down to $0 over her lifetime. This changes the amounts. Based on current IRS tables, there would be over $4 million left at her death instead of the $9 million.

The income generated by stretching the IRA is enormous. In the example, the IRA would have provided over $1 million in income to Sam and an additional $11 million in income to his daughter. In other words, the IRA would have generated over $12 million in income and still been worth over $4 million!

In this example, we used a Traditional IRA. A Traditional IRA provides a tax deduction when you put money into it, but then you have to pay taxes on every dollar when you take it out. In our example, assuming a 30% income tax rate, approximately $3,600,000 would have been lost to income taxes! If the remaining money in the account was withdrawn it could result in over $1.2 million in additional taxes. So almost $5 million is lost to income taxes!

If Sam had used a Roth IRA instead he would not have received a tax write-off each year he invested the $3500. On the other hand, there would NOT be ANY income tax on the distributions. In other words, the $12 million in distributions plus the $4 million left in the account could have all been used FREE from income tax! That’s the power of the Roth IRA.

The power to compound your money tax-free is a great way to accumulate wealth. If your money is in a Traditional IRA you may still be able to take advantage of this power by converting it to a Roth IRA. When you do, you’ll have to pay taxes on the amount taken out of the Traditional IRA. If you are under 59 ½ years old, the IRS waives the normal 10% early withdrawal penalty on the amounts converted.

If you are retired and plan on using the money in your Traditional IRA then it probably doesn’t make sense to convert it. If you don’t anticipate using it and your children understand the power of stretching your IRA, then converting to a Roth IRA might be beneficial.

You have the flexibility to spread the conversion over several years, allowing you to time the conversion to take advantage of drops in market value or years in which you are in a lower income tax bracket.

The rules surrounding IRAs are complex. For instance, you can’t convert a Traditional IRA to a Roth IRA if your Adjusted Gross Income is $100,000 or more. So make sure to talk with a competent advisor before proceeding or give me a call.

Nationally-syndicated financial columnist and Certified Financial Planner® Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He’ll answer your financial question – FREE at http://www.guardingyourwealth.com