This week, Congress threatened to kill a valuable estate-planning tool by eliminating the inherited–or “stretch”–IRA.
If your client inherits an individual retirement account or 401(k) he or she can choose to space the withdrawals over his or her lifetime instead of receiving the funds as a lump sum today, a payment that’s immediately taxable. In this way, the tax advantages of the IRA can continue throughout lifetime (or until the account is depleted).
Stretch IRAs can become even more valuable because, after the original beneficiary dies, the funds in the account can continue to be passed from generation to generation, thus prolonging the tax savings indefinitely.
In an effort to raise tax revenue, the Senate Finance Committee has proposed a measure that would eliminate these benefits by requiring that the funds be withdrawn within five years of inheritance. Because these measures would apply only to individuals dying after 2012, this year may be the last opportunity to defer income tax through the use of a stretch IRA.
The Senate Finance Committee Proposal
The Senate proposal would eliminate the stretch IRA as an estate planning tool, generating approximately $4.6 billion in tax revenue. The proposal would require beneficiaries of inherited IRAs and 401(k)s to liquidate these accounts within five years of receipt and pay the income taxes associated with the funds they receive.
If the proposed Senate measure is passed, the funds received by the beneficiary would be taxed as ordinary income, which could push some beneficiaries into higher tax brackets or increase the percentage of social security income that is taxed. Removing the funds from the IRA would also put them within reach of bankruptcy creditors.
The new rules would apply to people who die in 2013 or thereafter, though exceptions are built into the proposal for the original account owner’s spouse, beneficiaries within 10 years of age of the account owner, the disabled and children (until they reach adulthood).
Though the proposal raises important concerns, many anticipate that the measure will not pass anytime soon. The proposal is not included in the House version of the bill and Sen. Max Baucus, D-Mont., the bill’s strongest proponent, has indicated that he is open to finding other revenue sources.