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Will the New Retirement Asset Law Make Stretch IRAs Inelastic?

by
Spencer Wilson
on
6/12/2019
Will the New Retirement Asset Law Make Stretch IRAs Inelastic?

As a general rule, inheritances are tax-free, but a traditional IRA is one of a very few cases in which a beneficiary who inherits one will automatically end up with taxable income due to having to make RMDs (required minimum distributions). While inherited Roth IRAs will also result in mandatory RMDs, they do not have tax consequences since the contributions were made with after-tax money. Hence, stretch IRAs have become a popular tool in legacy planning and tax avoidance strategies.

Understanding Stretch IRAs

A stretch IRA is not a specific type of retirement vehicle like a Roth or traditional IRA. Rather, it's the name given to the tax planning strategy that preserves the contents of the IRA for future generations by "stretching" it out. They are most popular in legacy planning and preserving dynastic wealth since the IRA is allocated to the decedent's estate rather than cashed out in advance and is passed down from a younger beneficiary to the next, so it grows tax-free for as long as possible.

Since beneficiaries must take RMDs even if they do not want to, the younger that the beneficiary is, the less the RMD amount will be. Your 24-year-old grandchild is going to have a significantly lower RMD than your 55-year-old child. Therefore, your grandchild would pay lower taxes on the distributions and likely have that asset last well into retirement age.

However, a new provision of the SECURE Act (H.R. 1499) passed by the House in May 2019 is likely to put a snap in the elastic that makes IRAs stretch: One of the proposed rules would mandate that non-spouse beneficiaries must spend down inherited retirement assets within 10 years of the decedent's death. Of the proposed rules to increase overall retirement security for millennials and Gen Zers who, for the most part, lack retirement savings, it could come at the cost of the stretch IRA strategy. The House version would call for a complete depletion of the inherited IRA at the end of 10 years, while the Senate version, RESA, would allow the first $400,000 to be "stretched" and the remaining balance exceeding this amount to be depleted over five years after the owner's death.

Accelerating IRA Distributions Under SECURE and RESA, and Potential Consequences

This 10-year rule, and any others relating to H.R. 1499, has not been codified into law yet, so stretch IRAs can still be effectively deployed as the rule wouldn't go into effect for deaths prior to December 31, 2019. Both the House and Senate versions of the bill also contain exceptions for disabled and chronically ill beneficiaries, minor children, and beneficiaries who are less than 10 years younger than the decedent.

While the bill also includes a proposal to raise the RMD age to 72 since a larger number of seniors are now working for much longer and making catch-up contributions, the chief purpose of these bills is to generate more tax revenue by accelerating IRA distributions. If a beneficiary has to cash out the IRA's contents within 10 years of the decedent's death date, it doesn't necessarily mean that they must spend it down, but they would pay potentially exorbitant taxes on the distributions. If the RMD amount is based on five or 10 years instead of life expectancy, it could be exponentially higher than expected and unfairly push the beneficiary into a far higher tax bracket.

If the beneficiary is already in a high tax bracket, this would mean paying significantly higher taxes on the IRA distributions now than they would once they reach retirement age. If the beneficiary is in a low tax bracket and doesn't meet the exceptions for being disabled or chronically ill, being forced to take high RMDs could unfairly push them into a higher tax bracket and nullify eligibility for programs like food assistance or artist housing.

Options If Stretch IRAs Are No Longer a Viable Strategy

These proposed rules should be kept in mind depending on your financial situation and that of your beneficiaries. Would you be comfortable with your beneficiaries being mandated to spend down these assets within 10 years or less if you planned to leave them the money for long-term security opposed to a one-time transaction like purchasing a home? Are they capable of making the right decisions regarding that much cash on hand?

If stretch IRAs are no longer a viable tax planning strategy, other strategies likely to eclipse it would include converting traditional IRAs to Roth IRAs so that the contents could be easily reinvested upon distribution without causing the beneficiary to pay additional income taxes. Allocating IRA distributions and the accounts themselves to estates so the assets go into a revocable living trust is another probable strategy that some people will gravitate to even though individuals have a much higher taxable income threshold than estates do. 

IRA beneficiary trusts are a more complex maneuver that financial planners aren't likely to find worth the trouble, but they could be worth exploring for beneficiaries in higher tax brackets who need to toggle the cash flows from these trusts. Charitable remainder trusts are another strategy that some people may find to be a better solution than stretch IRAs depending on the financial status of the beneficiaries, and inadvertently paying more taxes on the distributions in comparison to receiving other assets without being taxed.

Overall, both SECURE and RESA are proposals that will materially change the way that retirement and tax planning are done with respect to bequests and inheritances. For beneficiaries, it's already difficult to go through losing a loved one and being faced with tax and legal hardships even if you leave behind a thorough estate plan. They already face difficulty in calculating RMDs and determining how much to withdraw while minimizing the tax impacts from their other income, and the pressure to withdraw even more in a relatively short time frame could completely shatter their own tax planning strategies and even foster poor financial decision-making.

Spencer Wilson writes for TaxBuzz, a tax news and advice website. Reach him at [email protected].

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Spencer Wilson

Spencer Wilson

Spencer Wilson, EA is a tax preparer based in Long Beach, CA. Spencer Wilson Financial Management Services has been serving the Greater Los Angeles Area and Orange County since 2004. <br /> We began in the heart of Naples in Long Beach and we continue to work hard offering tax preparation and planning, business accounting and bookkeeping and payroll services . <br /> We have helped many different people and businesses succeed financially and take control over their finances.

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