In case the SECURE Act passes Congress, we could be facing the elimination of the stretch IRA. But, there are a few maneuvers people can make to continue to protect their wealth and pass it down to their children. The proposed legislation is in Congress waiting to be passed. It’s not sailed through as many thought (and hoped) it would. And, this is good news for those who’ve spent their lives socking away enough in their retirement plans to retire comfortably and leave an inheritance for their loved ones in the form of inherited IRAs and other retirement plans.
If you’ve not heard about the SECURE Act and how it may affect your best-laid plans to leave a monetary legacy to your children—it’s time to educate yourself. This act passed the House in May with flying colors, but it is now stalled in the Senate. While there are many aspects in the bill that should make it easier for Americans to save for retirement, there’s an alarming provision that calls for the elimination of the stretch IRA. And, if part of your plan when you pass on is to leave a healthy balance in your retirement plan to your children, you need to understand what’s going on.
What Are the Consequences of the Elimination of the Stretch IRA?
Stretch IRAs allow non-spousal, inherited IRAs the ability for required minimum distributions (RMDs) to be recalculated and distributed based on the beneficiary’s life expectancy. Many of our grandparents and parents have used this tool to build wealth for their golden years—and also with the primary goal of leaving loved ones financially secure after their passing. The SECURE Act aims to change those current lifetime RMDs of the beneficiary to be totally withdrawn within a 10-year window instead.
Yes, in plain words, Congress is literally gunning for the funds (via taxation) in your IRA sooner rather than later.
So, consider the tax consequences that fall upon your loved ones if they have to take those distributions within 10 years. This means your initial and well intentioned plan to leave them set for life could end up costing them more. Here’s how:
Depending on the size of the inherited IRA, the beneficiary can possibly be bumped up into a much higher tax bracket than their current one. More income sounds great, but with that comes a higher income tax liability, as well. If they have children planning to apply for financial aid for college, this higher (but temporary!) income can dramatically affect whether financial aid is approved or denied. And, as stated in this Forbes article, the new 10-year rule applies to all qualified plans, including defined contribution plans: 401(k), 403(b), 457(b), 401(a), and profit-sharing plans. Also ESOP, cash balance plans and lump-sum distributions from defined benefit plans. As IRA are the general rollover tool for these plans, the elimination of the stretch IRA as we know it could have dire consequences.
This makes your next step critical: make an appointment with your financial advisor.
There are a few maneuvers you want to discuss with your financial advisor. As of the writing of this article, the SECURE Act has not yet passed. But if it does, this meeting can help you prepare to adjust your retirement planning relevant to the beneficiaries of your non-spousal IRA.
Alternative Estate Planning Tools besides the Stretch IRA
You may have already established a conduit trust, where the RMDs would pass straight through the trust, immediately to the beneficiary who then pays tax on that distribution. To avoid this, discuss how a conduit trust might be converted to an accumulation trust. Here, the trust becomes the beneficiary, and even though the IRA must still be fully distributed into the trust by that 10th year, those funds can stay in the trust and continue to accumulate. The trustee of the trust determines when any distributions of RMDs are made from the trust, and the trust bears the brunt of tax liability instead of the beneficiaries.
However, bear in mind that accumulation trusts can be taxed at higher trust rates. Depending on the size of your estate, this move may be more costly than your beneficiaries just biting the bullet and dealing with the 10-year rule. Again, your financial professional can help you navigate any complexities of this decision and evaluate the pros and cons therein.
Life insurance policies could move to the top of estate planning strategy list. Those seeking a way for any minor children to pay income taxes without depleting their entire inheritance left to them in an IRA might find life insurance an important tool to accomplish this. These policies can be left to a trust, thereby gaining trust protection to create long-term income in place of a stretch IRA. If you have health issues that make life insurance impossible, then discuss Roth IRAs and Roth 401(k)s with your advisor.
Roth IRAs and Roth 401(k)s
Roth IRAs and 401(k)s with a Roth option will work a little differently since these contributions were made post tax specifically to avoid income tax liability when RMDs are taken. As another Forbes article illustrates, beneficiaries of these plans are not liable for taxes on RMDs even though the account must be depleted within 10 years if the SECURE Act passes. However, using these plans as options to avoid stipulations of the elimination of the stretch IRA can be complex. Even though beneficiaries may not be taxed on RMDs, they will face taxation on the earnings. How? Because a prudent person would reinvest these earnings—and if your estate was a large one, provided the reinvestments fare well—the beneficiary would obviously incur income tax on that.
What Should You Do Now?
Again, we highly encourage you to speak with your financial advisor about the SECURE Act and the potential elimination of the stretch IRA. This article is meant for informational purposes only and should in no way be construed as advice. However, the points we’ve posed are legitimate strategies that can be discussed with your professional, who can advise you on the best move to make depending on your situation.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.