‘Stretch’ IRAs Have Lost Stretch Under SECURE Act

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Trust Planning for Inherited IRAs Should be Revised

By Jude Fox, CPA

“Stretch” IRAs have lost a lot of their stretch as a result of recently enacted federal legislation, and many Americans who hold IRAs may need to revise their beneficiary arrangements and estate plans as a result.

The SECURE Act changes several rules governing 401(k) plans and Individual Retirement Accounts (IRAs), and some of those changes will be popular with retirement savers, such as the ability to delay taking required minimum distributions until age 72, up from the former 70 ½.

However, one significant rule change curtails the use of the stretch IRA, which has been a widely used estate planning tool.

Under the old rules for IRA owners, beneficiaries who inherited an IRA upon the owner’s death could “stretch” the distributions over their expected lifetimes, regardless of age at time of the inheritance. If the assets held in an IRA were significant, stretching the distributions over a lifetime enabled beneficiaries to minimize taxes on the withdrawals.

But that ended on January 1, 2020, when the SECURE Act took effect. Under the SECURE Act, the old rules of stretch IRAs are limited to an owner’s spouse and beneficiaries who are disabled or chronically ill. Other beneficiaries now must take all distributions within 10 years of an IRA owner’s death.  As a result, the beneficiaries’ tax liability would be higher for each distribution.

*Exclusions to the rule would also include minors.  For a minor, the 10-year window starts when the beneficiary reaches the age of majority as defined by each state.

If you own an IRA and currently have beneficiary arrangements based on the expectation of a lifetime stretch, you should talk with your tax advisor and your estate planning advisor to determine your course of action.

An example of a common strategy that was used under the old law:

Betty is a 72-year-old widow who passed away on December 18, 2019. She left behind an IRA valued at $2 million. Betty has two adult children ages 45 and 40 whom she designated as equal beneficiaries of her IRA. But during her lifetime, she worried they might blow through the money, and she wanted to have some after-death control of IRA assets while also minimizing taxes. With the help of her attorney, she set up a See-Through Conduit Trust with her two children as beneficiaries and named the trust as the primary beneficiary of her IRA. At Betty’s request, the trust has specific language that allows only the trustee to distribute annual Required Minimum Distributions (RMDs) to the trust and to distribute the funds from the trust to the trust beneficiaries – Betty’s children. No funds remain in the trust and all funds received by beneficiaries are taxed at their own personal tax rates. Betty liked this because she could stretch her IRA over the life expectancy of the oldest beneficiary, which would be almost an additional 40 years, and it ensured the money wouldn’t be spent immediately. Additionally, the strategy ensured that the distributions would be taxed at reasonable marginal tax rates over a long period of time.

Under the new rules set forth in the SECURE Act

Betty’s strategy to exercise post-death control and minimize tax would be much more challenging. Consider an example with the same facts as above, however, Betty passes away on January 13, 2020. Under the new rules (and without an amendment to the trust language), there would be no distributions until the 10th year.  This means the IRA would be fully taxed, and Betty’s wish to minimize her children’s tax liability would be hindered.

Likewise, Betty’s wish to exercise post-death control over the amount of money her children would receive would be limited to 10 years unless she consults her advisors as soon as possible.  She can have her trust reviewed and modified to take distributions from years 1 through 9 by including language that gives the trustee discretion to act accordingly.     

Four options that could be good alternatives to combat the loss of the stretch IRA, depending upon your objectives:

  • Although a Roth IRA is also required to be distributed to non-spouse beneficiaries within 10 years of the IRA owner’s death, the beneficiaries can do so without incurring any tax consequences. The original account owner will have to pay income taxes on any portion of the traditional IRA that gets converted to a Roth in the year the conversion takes place, but this strategy might be appealing to IRA owners who are retired and are in a lower tax bracket than their heirs who are entering their peak earning years. The current tax rate environment also makes this strategy appealing.

  • For IRA owners who do not currently need their RMDs to meet their living expenses, they might consider using RMDs to purchase a life insurance policy.

    Example: Steve and Lisa are married and have $1 million in an IRA. They are required to take roughly $39,000 in annual RMDs but don’t need the money for living expenses. They purchased a second-to-die life insurance policy that pays out to their children income tax-free after the death of the second policy owner. Steve and Lisa can remain invested and continue to generate growth while ensuring their children receive the life insurance proceeds income tax-free.

  • If you have a large IRA and a large taxable estate, you might consider funding an irrevocable trust with a life insurance policy, known as an ILIT. Essentially, you would set up a trust for the benefit of your family and purchase a life insurance policy inside the trust. You would take distributions from the IRA and gift them to the trust with the intent that they would pay premiums on the life insurance policy.  Upon your death the life insurance proceeds would fund the trust that would allow for regular income to your beneficiaries in a controlled manner. In addition to being income tax-free and estate tax-free, the money inside the trust will remain protected from beneficiaries’ creditors.

  • If you are philanthropically inclined, the Charitable Remainder Trust can allow for beneficiaries to be taken care of during their lifetimes just like the stretch IRA allowed for, but once they pass away the remainder is donated to a charity. This is appealing because the initial IRA distribution to the Charitable Remainder Trust is non-taxable. Instead, tax is paid as the money is paid out to beneficiaries at the discretion of the IRA owner when they set up the trust.

The Betty example above shows why it’s so important for IRA owners with trusts as their beneficiaries to consult with their advisors as soon as possible.  Act now to ensure your post-death wishes are met and taxes are minimized.  To make changes to your IRA beneficiary arrangements as a result of the SECURE Act, or for a general review of your plans, please contact us.