Is the Stretch IRA Dead?
In December 2019, Congress passed the Setting Every Community Up for Retirement (SECURE) Act. One of the most significant changes is the elimination of the stretch provision for most beneficiaries of inherited retirement plans like IRAs and 401(k)s. What does this change mean for you? And what opportunities does it present?
What is a Stretch IRA?
Before the SECURE Act, you could leave your IRA to a younger beneficiary, such as a child or grandchild. The beneficiary, in most situations, is then able to take required minimum distributions (RMDs) over his or her lifetime. Meaning the beneficiary takes relatively small distributions each year as the retirement account distributes over many years. This allows the tax benefit of the IRA to last much longer. The funds in the retirement accounts maintain either their tax-deferred or tax-free status over the beneficiary’s lifetime.
Many people believe that the reason for the partial elimination of the Stretch IRA is that Congress thinks that tax-favored retirement plans are meant for retirement, not for passing on wealth to heirs. This change is also a great revenue raiser. The Congressional Research Service estimates that the elimination of the stretch provision will generate an additional $15.7 billion in tax revenue over the next decade.
What Are the New Rules?
If you are the beneficiary of a retirement account for someone who died before January 1, 2020, then you are still able to take advantage of the Stretch IRA provisions. If you are the beneficiary of a retirement account for someone who dies after December 31, 2019, then the new rules apply to you. Meaning there will be different rules for inherited retirement accounts based on the date of death of the original account owner.
The new rules severely limit the ability to Stretch IRAs. Most non-spouse beneficiaries will have to withdraw the entire retirement account balance within ten years rather than a lifetime. This may have significant tax repercussions. The beneficiary will have to pay tax on the inherited IRA much faster. The amount you withdraw will also be more substantial, which may push you to a higher tax bracket. It will also mean that you will be paying tax on investment earnings such as dividends and interest if you invest the money.
Exceptions to the New Stretch IRA Rules
Congress made some special exceptions regarding the start date for the change to the Stretch IRA provisions for specific plans. Meaning the beneficiaries of these plans will be able to continue to take advantage of the Stretch IRA rules longer.
- For a collectively bargained plan, the changes are effective January 1, 2022, unless the collectively bargained agreement terminates sooner.
- Government plans such as 403(b) and 457 plans, as well as the Thrift Savings Plan, continue the old stretch rules until January 1, 2022.
- The change in the after-death minimum distribution rules does not apply to a qualified annuity. These are annuities in which individuals have already irrevocable annuitized over a life or joint life expectancy, or in which an individual has elected an irrevocable income option that will begin at a later point. These annuities will follow the already-binding provisions of the annuitized contract.
Who Can Still Stretch IRAs?
There are five groups of beneficiaries that may still take advantage of the Stretch IRA provisions. The law calls these people “eligible designated beneficiaries.” The eligible designated beneficiaries include the following:
- A surviving spouse;
- Disabled beneficiaries;
- Chronically ill beneficiaries;
- Beneficiaries not more than ten years younger than the owner; and
- Minor children of the retirement account owner.
Following the death of the retirement account owner, the remaining retirement account balance may be distributed over the life of the eligible designated beneficiary, beginning in the year following the year of death. This enables the beneficiary to take advantage of the Stretch provision. However, once the eligible designated beneficiary dies, the successor beneficiary (the beneficiary’s beneficiary) must withdraw the account balance within ten years after the death of the eligible designated beneficiary.
An IRA owner dies in 2020 and leaves his IRA to his brother, who is five years younger. The brother may stretch the IRA over his lifetime. He must take regular RMDs beginning the year after he inherits the IRA. When the brother dies, he leaves the IRA to his son. The son is subject to the 10-year rule and must withdraw the entire account balance by the end of the 10th year.
Once a minor child of the retirement account owner reaches the age of the majority, the balance in the account needs to distribute within ten years after that date. The age of majority is age 18 for most states, including Kansas and Missouri. The Internal Revenue Code specifies that you can treat a child as having not reached majority if they have not completed a “specified course of education” and is under the age of 26. The beneficiary may continue to use life expectancy to calculate the RMD if both of the requirements are met. Once the beneficiary is deemed to reach the age of majority, then he or she is no longer an eligible designated beneficiary and is now subject to the new 10-year rule.
An IRA owner who lives in Kansas dies in 2020 and leaves his IRA to his 7-year old daughter. The daughter may stretch the IRA, which means she takes “regular” RMDs, beginning the year after she inherits until she graduates from college at age 22. Once she graduates, the 10-year rule applies, which requires the entire inherited IRA to be fully distributed by the end of the year in which she turns 32.
Is My Trust Impacted by the Change to the Stretch IRA Rules?
Trusts are impacted by the new Stretch IRA rules. In fact, many people are calling these changes a disaster. The rule changes have made many of the prior estate planning provisions irrelevant. If the beneficiary of your retirement account is a trust, then you need to get the trust reviewed to make sure the trust language does what you intend.
There are two types of trusts: conduit and accumulation. Many people have set up trusts which use “conduit” or “pass through” language. With a conduit trust, RMDs are paid from the inherited IRA to the trust and then paid from the trust to the trust beneficiaries each year. No RMDs remain in the trust. The beneficiaries pay tax on the RMDs at their own tax rates. The trustee has no choice on whether or not to distribute the money to the beneficiary. This worked well when the IRA distributions were able to be stretched over a lifetime. With the loss of the Stretch IRA provisions, the entire retirement account balance must distribute to the beneficiary of most trusts within ten years. This may be a disaster if the beneficiary is a spendthrift or has credit issues.
Many people may now be better served by an accumulation trust. Under the rules of an accumulation trust, the trustee can decide when funds distribute to a beneficiary and the amount to distribute. The trustee has the discretion to retain the funds in the trust to protect and preserve the funds. A downside to this is you must pay taxes at the trust level. Trusts pay tax at the highest tax rate once taxable income exceeds $12,950 in 2020.
What Do I Need to Do Now?
The end of the Stretch IRA can have a devastating effect on tax planning and estate planning. Now is the time to review your estate plans, financial plans, and tax plans to see what steps you can take to mitigate the tax hit on your retirement accounts.
One financial strategy you should consider is Roth conversions. One comment we have heard repeatedly from our clients is that they did not work their lifetime to leave money to Uncle Sam. Roth conversions are a way to minimize the amount you pay in taxes. Roth conversions allow you to decide when you pay the tax and the amount you pay. The current tax rates are at historically low levels. These rates, currently, increase on January 1, 2026. Now is the time to analyze if a Roth conversion benefits you and to determine the amount to convert. Determining the optimal Roth conversion amount is much more than a breakeven analysis. Usually, one does Roth conversions over many years, taking advantage of the lower tax brackets. We can help you develop a Roth conversion strategy.
Another strategy to consider is charitable giving. The SECURE Act allows those over 70 ½ years of age to make qualified charitable distributions while they are living. If you are charitable, you may want to leave a portion of your pre-tax retirement account to charity and leave other assets to your other beneficiaries. The charity does not have to pay tax on the retirement account. Some may want to establish a Charitable Remainder Trust to maximize the benefit of your retirement account for both your beneficiaries and the charity you choose.
Consider Life Insurance
Life insurance is another strategy to consider. Many beneficiaries will be in their peak earning years when they inherit the retirement account. The extra income from having to withdraw the funds in ten years may cause the beneficiary to pay income tax at a higher rate than they would have paid under the stretch provisions. One can use life insurance to make them whole for the extra tax they pay. Life insurance may also be valuable to a surviving spouse to use as a vehicle to pay the tax on Roth conversions after the death of the first spouse. There are other life insurance strategies as well, depending on your financial plans and estate plans.
The above are just a few strategies to consider. The rules have changed, which means you need to update your financial plan, including your tax plan and estate plan, to make sure it still does what you desire. We cannot bring back the Stretch IRA rules, but with proper planning, we can help you mitigate the negative impact this change has on you and to make sure you are not missing out on an opportunity to do better. Let us help you create or review your plan today. Schedule a complimentary consultation below or call us at 913-393-1000 to get started today.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.