If you are – or expect to be – the owner of a $500,000 or greater IRA or 401k, you’ll want to monitor the progress of the SECURE (Setting Every Community Up for Retirement Enhancement) Act, recently passed by the House, by an overwhelming 417 – 3 margin. Among its provisions is the elimination of the so-called “Stretch” IRA for non-spouse beneficiaries. Surviving-spouse beneficiaries will not be affected by the new rules, should they eventually pass both Houses and become signed into law.
Current law allows non-spouse IRA beneficiaries, no matter their age, to make withdrawals from inherited IRAs over the course of their remaining lives. The SECURE Act would force distributions over 10 years; with exceptions for minor children, beneficiaries who are disabled or chronically ill or who are less than ten years younger than the deceased account owner. The provisions would go into effect on January 1, 2020; with existing stretch IRAs being grandfathered.
The House bill has thus far stalled in the Senate, which has a similar bill mandating withdrawals over a 5-year period. But the “Stretch” has been on the chopping block for years. Whether its elimination will pass in this Congress – or in some future year – is somewhat uncertain. Either way, it’s prudent to start planning for its demise.
Provisions on Death of Owner
Assets in an IRA don’t just disappear on the death of its owner. By default, IRA accounts become distributable to the account owner’s estate. Or, in the alternative, IRA accounts allow for specific direction of the assets on the account owner’s death with the naming of both a primary designated beneficiary and contingent beneficiaries – in the event the primary beneficiary pre-deceases the account owner. Typically, a married IRA account owner will name a spouse as the primary beneficiary and children and/or grandchildren as contingent beneficiaries. But you can name other relatives, friends or even charities as beneficiaries.
Paying the Piper: Required Minimum Distributions (RMDs)
Leaving aside for the moment what happens on the death of an IRA owner, it’s important to understand the distribution rules while you are still alive:
Traditional IRAs (and 401ks, which can eventually be rolled over into IRAs) represent a type of long-term bargain made with the IRS. Contributions are deducted from taxes when made. Plus, earnings and capital gains are not taxed when realized. However, withdrawals are taxed at ordinary income rates. And annual distributions, based upon your life expectancy, become required once you turn age 70 ½. The first-year withdrawal amount is 3.65% of the account value. The withdrawal percentage increases by a small amount every year until age 115, after which you are required to withdraw half the account value every year. You should live so long!
The Roth versions of these accounts represent the opposite bargain. Contributions are post-tax. During your lifetime there are no mandatory distributions. But the eventual withdrawals – both contributions and earnings – are tax-free, presumably for as long as the account exists.
Beneficiary IRAs: Death and Taxes
In the inestimable words of Benjamin Franklin: Nothing is certain except death and taxes. And nowhere are these more certain than with beneficiary IRAs.
Estate: When the account owner’s estate is the beneficiary (either named or by default), the account assets must be fully withdrawn over no longer than five years and be fully taxed – unless the account owner had already reached age 70 1/2, in which case the ultimate beneficiaries may use the deceased owner’s life expectancy.
Surviving Spouse: As a surviving spouse, named as a beneficiary, you have two planning choices on the death of the owner – aside from cashing it in and paying the taxes all at once. 1) You can treat the IRA as your own, either by retitling the account in your own name or by rolling the account over into your own IRA account, which generally allows you to take withdrawals over your own life expectancy; or 2) You can treat yourself as the beneficiary of the existing account, which generally allows you to take withdrawals over the life expectancy of your deceased spouse.
Which of these two choices is most beneficial will depend on the financial circumstances and the relative ages of the two spouses. These choices will not change under the pending legislation.
Non-Spouse – (This is the stretch): Under current law, a non-spouse beneficiary, such as the 40-year old child of an IRA account owner whose spouse may have pre-deceased, can take distributions over his/her own life expectancy. The first year required minimum distribution would be 2.29% – or $22,936 on a $1,000,000 account – based on an actuarial life expectancy of 43.6 years. Assuming a marginal tax rate of 32%, the tax due would be $7,339 and the account would continue to grow, tax-deferred, with slightly increasing annual required withdrawal percentages. Under the proposed legislation, the first-year withdrawal would be $100,000, with a tax due in the amount of $32,000. You can see the difference. And for many beneficiaries, such large distributions would move them from a relatively low marginal bracket to a much higher bracket.
But in a very incisive commentary, Aaron Szapiro, director of policy research at Morningstar, demonstrates that it may not be quite as bad as it looks.
[pullquote align=”normal”]just because you are required to take a distribution, you are not required to spend it. [/pullquote]
Szapiro makes the point that just because you are required to take a distribution, you are not required to spend it. You can reinvest the cash-flows instead, in a non-IRA account. In his example, the beneficiary would only be about 15% behind in total wealth after ten years.
Trusts – (Where it gets tricky): Thus far we’ve been examining how a financially mature and savvy individual IRA beneficiary can prolong withdrawals to allow for continued tax deferred growth within the account and spread out the tax liability over as many years as possible. But we may also have a need to plan for beneficiaries who are minors or for whom having control over the account in adulthood may tempt them to invest imprudently or become a spendthrift. Remember, an IRA beneficiary is permitted to withdraw more than the RMD and may drain the account on a whim.
Prudent estate planning in other circumstances often employs the use of trusts to protect such beneficiaries. And IRAs can be made payable to the trustee of a trust to serve this purpose. Thousands of existing estate plans have incorporated this technique. One of the reasons for this kind of planning is the 2014 decision by the US Supreme Court in Clark vs Rameker, holding that inherited IRAs do not receive the same creditor protection in bankruptcy as when still owned by the original account owner. But in accelerating distributions, the SECURE ACT would wreak havoc on these plans.
Naming a “trust” as the beneficiary of an IRA does not eliminate the need for the trustee to take required minimum distributions on behalf of the non-spouse beneficiaries of the trust. If there are multiple such beneficiaries, the IRS will “see-through” the trust and the life expectancy of the oldest is used to determine the withdrawal schedule, even if some payments will be made by the trustee to younger ones. (Which is why it may be prudent to provide for a separate “see-through” trust for each beneficiary.)
There are basically two different kinds of trusts that can be settled for an IRA. 1) A “conduit” trust – which mandates that the distributions received by the trustee from the IRA custodian then immediately be paid out to the trust beneficiary and taxed to him/her at their own marginal tax rate. 2) Or an “accumulation” trust, which gives the trustee discretion, after receiving the RMDs; either to make distributions to beneficiaries and have the taxes be paid by them or to retain the distributions in the trust (for further investment outside the IRA) – but pay the taxes on the RMDs at the compressed tax rates for trusts, which reach the top 37% bracket at just $12,750 in income.
Either one of these scenarios is made extremely prohibitive under a regime in which RMDs are mandated from a large IRA over a short period of time, such as five or ten years. Forcing large distributions to a spendthrift defeats the purpose of a trust in the first place. Accumulations of large IRA distributions will clearly be less accumulative if they are subject first to a 37% tax.
What’s the best alternative to the stretch?
Planners throughout the profession have been examining ways to mitigate the impact of the demise of the stretch IRA. It is well to keep in mind that this problem is probably limited to relatively large IRAs, say above $500,000; those in which a ten percent per year annual distribution is above an amount likely to be consumed by heirs. Nobody yet knows what the best solutions will be for seven figure IRAs. But here a few of the ideas being mentioned:
Roth conversions: The 2017 Tax Cut and Jobs Act (TCJA) ushered in a period of generationally low marginal income tax rates – at least until 2026 when the law sunsets; making Roth conversions during the account owner’s lifetime potentially attractive as a way to emulate spreading beneficiary distributions out over more years. For married taxpayers the 22% bracket goes up to $168,000 and the 24% bracket reaches $321,000. A 55 year-old could consider a series of Roth conversions over 15 years – before social security and RMD’s kick in. Of course, as with any Roth conversion strategy, the taxpayer should have separate funds from which to pay the tax liability on conversion. The Roth account would have no RMDs for the account owner or spouse during their lifetimes. And beneficiary withdrawals from the inherited Roth, even in a trust scenario (although subject to accelerated RMDs) would be tax-free.
But it still makes sense to keep some money in a traditional IRA because those withdrawals may be able to be sheltered with business losses or medical expenses or used for Qualified Charitable Contributions once you are over 70 1/2. And your heirs, especially if you have several (even if SECURE ACT passes) may be in lower brackets with the more modest distributions that result from a smaller traditional IRA.
Spousal Disclaimer: A surviving spouse may want to disclaim a portion of an IRA to children (assuming they are properly named as contingent beneficiaries) at the time of the death of the first spouse. The children would have to withdraw over a 10-year period. But the surviving spouse may live for another 15 or 20 years and then the children would have another 10 years to withdraw from that beneficiary IRA. Making for a total withdrawal period of 30 or 40 years.
Charity: An IRA can be the ideal asset in an estate to be left outright to charity. This avoids entirely the question of beneficiaries managing the future income tax liability. More tax efficient assets, with a stepped-up basis, can be left to family members instead.
An IRA can also be made payable on death to a charitable remainder trust, in which the beneficiaries receive income for their lives – which may be a lot longer than 10 years – and the remainder is paid to charity.
Life Insurance: An IRA owner during his/her lifetime could use distributions to fund a life insurance policy in a trust that would pass tax-free at death and be available to support beneficiaries over their lifetimes.
The purpose of eliminating the stretch IRA is to pay for more broadly supported, but revenue costing, provisions of the SECURE Act; such as raising the age for RMDs to 72 or even 75 as provided in the Senate bill. There is also the acknowledgement that favorable tax treatment for IRAs is designed more for the benefit of living retirees than as an estate planning device. Will it pass?
Ordinarily one would think a bill passed by a 417 – 3 margin in the House would make it through the Senate, possibly even by unanimous consent. But several Senators have placed “holds” on the bill for parochial reasons and Majority Leader McConnell is reluctant to bring the bill to the floor for a vote. Supporters (there are provisions that the insurance industry badly wants) are holding out hope that the bill will be attached to one of the “must pass” spending bills to be entertained before the end of this Congress.
We shall see.