While partisan politics rage, the U.S. House of Representatives nearly unanimously passed a bill that would reform key aspects of America’s retirement laws. The SECURE Act passed in a 417-3 vote in May and contains a provision to eliminate the Stretch IRA and replace it with a 10-year payout for most any beneficiary that is not your spouse. Examples of affected, non-spouse beneficiaries typically include children, grandchildren or trusts.
Stretch IRAs allow designated beneficiaries to extend distributions from inherited IRAs over their lifetimes. For example, a beneficiary 30-years old would be required to take less than 2% of the prior year-end account balance as an initial required minimum distribution (RMD). The RMD percentage increases yearly but can be stretched more than 50 years.
The Senate is considering its own bill which might reduce the payout to just five years. Consider the same 30-year-old beneficiary. She now takes RMDs over five years or 20% yearly. For large IRA owners, that will likely mean much more goes to income tax and less after taxes to your child.
If we suppose a $1 million IRA and no growth, a 20% RMD equates to an additional $200 thousand hitting your child’s tax return. Layering this on top of income they are already earning, their total taxable income will be pushed into progressively higher rates.
The larger your IRA, the fewer kids you have, and the more successful your kids are with their own incomes, the higher the percentage of your IRA will go to Uncle Sam rather than your kids.
What does this mean for those who have named a trust as their IRA or plan beneficiary? Potentially worse results.
There are two types of IRA trusts – conduit trusts and accumulation trusts. Under current rules, if the IRA trust is drafted in a certain manner (called see-through trust), the trust beneficiaries can be treated as if they were named directly and the stretch payout will be permitted. These trusts may offer many benefits, most common of which are asset protection from a creditor or potential ex-spouse and control by not permitting your beneficiary to cash out the IRA in one fell swoop.
With a conduit trust, RMDs are paid from the inherited IRA to the trust and then from the trust to the beneficiaries each year. No RMDs remain in the trust. The beneficiaries pay tax on the RMDs at their own personal tax rate. In effect you have a similar tax result as if your child was the designated beneficiary and not the trust.
With an accumulation trust, the trustee has discretion whether to pay out the RMDs to the beneficiaries or retain those funds in the trust to preserve them. If the funds are retained, they will be taxable to the trust at the high trust tax rates, and the accelerated payout due to the loss of the Stretch IRA will make the tax cost significantly greater.
What To Do
Congress has exemplified the belief that retirement accounts are for retirement and should not be employed as an estate planning vehicle, as the Stretch IRA can be creatively used. Frankly, it was surprising to many that the elimination of the Stretch IRA wasn’t included in the 2017 tax reform. While the elimination of the Stretch seems inevitable, there are things that can be done.
First, you need to review your own planning, including all IRA beneficiaries and IRA trusts. You’ll also need to look at longer-term retirement and estate projections to evaluate how much tax risk is likely to exist in your current plan.
Second, if proactive action is deemed advisable, certain strategies become more valuable. Consider converting money to tax-free Roth IRAs at today’s low tax rates. Use an asset-location strategy, placing lower growth and more tax-inefficient portfolio assets in your IRA and higher growth, tax-efficient assets in your Roth and trust accounts.
Life insurance will also re-emerge as a tax-efficient solution for many large IRA owners. But caveat emptor, as high commission products and conflicts of interest are rife within this marketplace. Yet, used properly, life insurance will be able to maximize benefits to heirs and allow asset protection and control benefits of a trust to be realized.