Stretch IRAs: Possible Changes That May Affect You

Ken Weingarten |

It is usually recommended that individuals name beneficiaries on their IRAs as it is an effective and simple estate planning strategy. Once a beneficiary inherits an IRA, however, there are various factors to consider when thinking about what to do with these assets, especially when it comes to distributions.

When one inherits an IRA, Required Minimum Distributions will have to be taken and beneficiaries of Inherited IRAs are faced with a few distribution options:

  1. For surviving spouses only – Rollover the deceased spouse’s IRA into your own. If a spouse, below age 70 ½, inherits an IRA, it is generally advisable to roll over the deceased spouse’s IRA into their own and defer taking RMDs.
  2. Take a Lump-Sum Distribution and pay ordinary income taxes on it. Generally, this is not a good idea from a tax standpoint. It can push you into a higher tax bracket for that year, thus resulting in a higher tax liability.
  3. Distribute the IRA within a five-year timeframe. If the new IRA holder has not taken RMDs yet, one has the option to delay taking distributions with the caveat that after a five-year period, the entire IRA must be distributed. This delay can provide some breathing room to do some tax planning in order to minimize the overall tax liability faced with the full distribution of this IRA.
  4. “Stretch” out the Required Minimum Distributions of the IRA over a lifetime. The IRS provides an age-factor table which one can calculate how much to distribute annually based on the age of the beneficiary. This is the usually the preferred option for most individuals as it minimizes the overall tax liability.

The Stretch IRA

The benefits of a Stretch IRA can help to ease the tax burden for younger, non-spouse individuals, who inherit sizable IRAs. Depending on the beneficiary’s tax bracket, minimal taxes will be paid as well as allowing the assets within the Inherited IRA to grow tax-deferred.

Potential Changes to Stretch IRA Rules

The SECURE Act, which is likely to pass and be signed into law this week (it has been attached to the must-pass government spending bill), will affect potential non-spouse beneficiaries starting in 2020.

Specifically, it will eliminate the ability to “Stretch” an IRA and cap the allowable distribution timeframe to 10 years rather than a lifetime. This does not mean that one will have Required Minimum Distribution for 10 years but rather, a non-spouse beneficiary has 10 years to distribute the entire IRA, thus effectively accelerating IRA distributions. (Note: This change will apply to non-spouse beneficiaries who inherit an IRA after 2019.)

Non-spouse beneficiaries of sizable Inherited IRAs are likely to be hit a bigger tax liability going forward. For example, a beneficiary with a $1 million IRA, will have the following distribution options: a lump sum distribution (not recommended) or evenly spread out distributions ($100,000/yr) over the 10-year period (In this simple example, we assume there is no growth in the assets, which is unlikely to be the case.) The latter can minimize the tax liability but $100,000 of taxable income can still create significant tax consequences, especially for working individuals with significant income.

Possible Planning Strategies

Individuals with substantial retirement assets may want to consider some of the following strategies to circumvent or minimize the potential tax liability for their beneficiaries:

  • Beneficiary Management – Directly naming multiple beneficiaries from the IRA can spread out the tax hit. For example, if an IRA is split amongst five beneficiaries, over a ten-year period, the tax impact would occur over 50 ‘tax years’. Assuming all five beneficiaries are in a low tax bracket, the distributions would be spread out and thus minimize tax liabilities.
  • Roth IRA Conversions – Current owners of sizable IRAs may also consider Roth conversions. This can effectively reduce the value of an IRA once it is inherited, which can minimize the tax liability for beneficiaries. While the Roth IRA will also be subject to this 10-year distribution period, distributions from a Roth IRA will be tax-free.
  • Increasing Qualified Charitable Distributions – Each IRA owner (age 70.5+) can donate up to $100,000 per year. The advantages of this are two-fold:
    • 1. It allows an IRA owner to reduce the value of their IRA. Once a non-spouse beneficiary inherits this IRA, its reduced value can hopefully minimize tax liabilities.
    • 2. Qualified Charitable Distributions are excluded from income on a tax return, thus providing a tax benefit in the year the contribution is made.

Ultimately, there will be significant changes to estate planning strategies in place. Given that these changes are very likely to pass, one should consider consulting with a financial planner regarding these changes and the potential effects it could have down the line.

Weingarten Associates is an independent, fee-only Registered Investment Advisor in Lawrenceville, New Jersey serving Princeton, NJ as well as the Greater Mercer County/Bucks County region. We make a difference in the lives of our clients by providing them with exceptional financial planning, investment management, and tax advice.