When the Setting Every Community Up for Retirement Enhancement (SECURE) Act was enacted on January 1, 2020, it implemented some of the most significant changes to retirement plans that have been made in over a decade. One of these changes came as a disappointment to many IRA owners: the requirement that non-spousal beneficiaries of “stretch IRAs” withdraw all of the assets from the account within ten years. This new stipulation is widely viewed as having effectively eliminated the stretch IRA, leaving those who were planning to use one searching for alternatives for passing assets to their heirs in a tax-efficient manner.
What is a stretch IRA?
A stretch IRA is not a type of IRA, but rather an estate planning tool designed to allow beneficiaries (typically non-spouses) who inherit IRAs to withdraw the assets of the account in a way that minimizes their taxation and allows the IRA assets to continue growing tax-free for as long as possible.
Beneficiaries must take required minimum distributions (RMDs) from the IRA each year. Prior to enactment of the SECURE Act, the RMD amounts were based on the beneficiary’s age and how much money was in the account. As a result, beneficiaries could “stretch” the RMDs out over the course of their lifetimes—a strategy that was particularly effective for younger beneficiaries, such as the original account owner’s grandchildren or great-grandchildren. This was due to the fact that the more years remaining in a beneficiary’s life (based on IRS life-expectancy tables), the smaller the distributions they were required to take each year. Therefore, the taxes owed on each RMD were lower, and the assets within the IRA had more time to grow tax-free—thereby ultimately increasing the value of the account.
How have stretch IRAs changed under the SECURE Act?
Under the new SECURE Act, non-spousal beneficiaries who inherit IRAs after December 31, 2019 can no longer stretch the RMDs out over their lifetimes; they now must withdraw all assets from the account within ten years of the original account owner’s death. This rule does not apply to spouses, disabled or chronically ill beneficiaries, minor children, beneficiaries who are not more than ten years younger than the original account owner, or those who inherited an IRA prior to the beginning of 2020.
IRA distributions are generally taxed at the beneficiary’s current income tax rate—so more sizable distributions can result in an unexpectedly high tax burden, particularly for beneficiaries who are near their peak earning years. Therefore, stretch IRAs will no longer serve as the most tax-efficient estate planning tool in many cases.
Alternatives to the stretch IRA
If you are seeking ways to transfer wealth to your heirs—without leaving them with a high tax bill—the following options may provide effective alternatives to the stretch IRA:
- Convert traditional IRAs to Roth IRAs. Traditional IRAs are funded with pre-tax dollars, while Roth IRAs contain after-tax contributions. Therefore, beneficiaries do not pay tax when they inherit Roth IRAs as the tax is essentially prepaid by the original owner. Since Roth conversions generate taxable income, you will likely want to spread the process out in a series of conversions over time in order to minimize taxation. However, since current income tax rates—which are historically low—are only scheduled to remain in effect until 2026, Roth conversions may be a particularly attractive option over the next few years.
- Use withdrawals from the IRA to purchase life insurance. Using this strategy, your beneficiaries will receive tax-free death proceeds from the insurance plan when you pass away. They will also inherit a lower (and less-taxable) amount from your IRA if you drew down the account balance in order to fund life insurance payments. Keep in mind, however, that the cost of insurance premiums depends upon your age and health, so this option may not be cost-effective if you are older or in poor health.
- Shift IRA money to other assets to be bequeathed to heirs. You may also use IRA withdrawals to purchase valuable assets, such as stock and real estate. Upon inheriting these assets, your heirs will receive a step-up in basis equal to the asset’s value; they will only pay tax on the asset’s appreciation if and when they sell it after the time of inheritance.
As you consider options for leaving a legacy for your loved ones while minimizing the taxes they will be required to pay, working with experienced professionals with tax and wealth management expertise will help optimize financial benefit for you and your heirs. Contact us today to discuss your strategy!
-Stephanie Vance, J.D.
(Sources: https://www.investopedia.com/ask/answers/09/stretch-ira.asp, https://www.kiplinger.com/article/retirement/T032-C000-S004-alternate-strategies-for-stretch-ira.html, https://www.marketwatch.com/story/the-secure-act-killed-the-stretch-ira-here-are-alternatives-for-your-inheritance-2020-02-06).
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