The Stretch IRA Is Gone. What Now?
The SECURE Act, which was signed into law at the end of 2019, made many changes to the laws around retirement contributions and withdrawals, with very significant alterations made to traditional IRA inheritance rules. If you own an IRA, particularly a sizeable one, the conventional wisdom about how to pass on that IRA to your spouse and children may no longer apply.
Traditional IRAs can be passed to a spouse or non-spouse beneficiary. Under the SECURE Act, there are no changes for surviving spouses: these beneficiaries can roll an inherited retirement account into their own IRAs and use the account as if they were the original owner, just as they could before the Act’s passage.
However, the SECURE Act made significant changes for non-spouse beneficiaries. Prior to the Act being passed, a non-spouse beneficiary could “stretch” an IRA by taking required minimum distributions (RMDs) based on his or her own life expectancy rather than the life of the original owner. Spreading out distributions over a lifetime was generally advantageous to the beneficiary, especially if the beneficiary was significantly younger than the original account owner: he or she would take smaller RMDs over a more extended period, which would allow for greater tax deferral and more than likely more significant wealth accumulation in the account.
Under the SECURE Act, an inherited IRA must now be fully distributed to the beneficiary within ten years, except if the beneficiary is a surviving spouse, an eligible minor, a person less than ten years younger than the original owner, or the disabled or chronically ill. The SECURE Act does not make specific requirements for how an account is distributed during that 10-year period, which does provide some flexibility for the account owner to time the distributions as most benefits them. The beneficiary could take a lump-sum distribution at the beginning or end of the ten years, withdraw a set amount every year, or vary their annual distributions depending on their other income.
While this is undoubtedly a significant change in the law, many IRA beneficiaries may not notice much of a difference. It may not matter much year-over-year if a smaller IRA is distributed in 10 years or 20 years. Owners of very large IRAs or owners of IRAs who had planned to pass them to young children for maximum tax deferral, however, are looking at a very changed landscape for IRA inheritance, which will require new strategies.
Here’s a few options for you to consider if you have a large IRA to pass to your heirs.
Pass IRA Assets to Younger Beneficiaries Rather Than Spouses
Especially if both spouses have significant IRAs and a significant age difference between them, it can be advantageous to name younger beneficiaries as primary on their IRAs rather than each other. Before the SECURE Act, it was generally most advantageous for spouses to name each other as beneficiaries; e.g. upon the death of Spouse A, Spouse B would inherit the IRA as a spousal rollover, and at Spouse B’s death, both IRAs would transfer to their child, who could stretch IRA distributions over their own life expectancy. Now, however, Spouse A could pass their IRA directly to their child and begin the 10-year clock on distributions for that IRA, and then Spouse B would do the same upon their death. This would allow their child to take distributions from two accounts over some period that is longer than 10 years.
If only one spouse has a significant IRA, it may be worth considering naming one or more younger beneficiaries as primary beneficiaries on half of the IRA assets, with the remainder going to the other spouse. That way, the ten-year clock would begin upon the death of Spouse A on half of the IRA assets. Years later, when Spouse B passes away, a new ten-year clock would apply to the remainder of the IRA assets. The less those ten-year periods overlap, the more distributions are spread out, and the lower the tax impact will be.
Charitable Remainder Trusts
IRA owners who also have an interest in making a significant contribution to charity as a part of their estate may choose to partially simulate a “stretch” IRA by creating a Charitable Remainder Trust (CRT). CRTs are split-interest trusts that pay some amount to lead beneficiaries for a specific term, with the remainder interest passing to charity. The lead beneficiary is often the donor, but they can also be younger members of the donor’s family who would otherwise have inherited an IRA.
To use a CRT to simulate a stretch IRA, the IRA owner would create a CRT and name their child or other relative as the beneficiary of the CRT. They would then name the CRT as the beneficiary of the IRA in question. When the IRA passes to the CRT, it would then be distributed to the beneficiary over the trust term rather than the IRA’s 10-year requirement, with the remainder interest ultimately going to the charity of the IRA owner’s choosing. CRTs have no minimum distributions other than a 5% minimum payout requirement, and there are also no penalties on early distributions, adding flexibility for the beneficiary.
As with IRA distributions, the CRT distributions would be taxed as ordinary income to the beneficiary, but only up to the point at which all pre-tax IRA contributions were distributed from the CRT. This essentially “freezes” the value of the IRA at the date of death value, meaning that any investment growth beyond the original value of the IRA would be taxed at more favorable capital gains rates.
Charitably-minded IRA owners also have the option of leaving their entire IRAs directly to charity without the use of a trust, or taking advantage of Qualified Charitable Distributions (QCDs) during their lifetime to reduce the value of their IRAs.
Roth IRA Conversions
The owner of a large IRA account could convert that IRA into a Roth IRA before his or her death, which would ensure the beneficiary inherited the account without a tax burden or distribution requirements. Roth conversions can often be advantageous, but that is highly dependent on the individual situations of the IRA owner and the beneficiary. For example, if the beneficiary is in a significantly lower tax bracket than the original account owner, it may be more advantageous to let the beneficiary pay the taxes on the traditional IRA distributions rather than converting.
These are just a few strategies that owners of large IRAs might consider in light of the SECURE Act. As is often true in personal finance, the right strategy for you is highly dependent on the particulars of your situation, so I would encourage you to consult with a trusted financial advisor or estate planner to determine the best way to pass your assets to your heirs.
Disclosure: This article is for informational purposes only and is not a recommendation of a particular strategy. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management. Follow me on LinkedIn. Check out my firm’s website or follow us on Twitter.