No one is a bigger fan of the so called “stretch IRA” than me. I’ve been touting its benefits for over 20 years. The stretch IRA is a term that describes how an inherited IRA can be extended (“stretched”) over the lifetime of an individual IRA beneficiary if the IRA was set up properly and the beneficiary knows what to do after death.
But the stretch IRA may be on the chopping block. Congress is constantly looking for new revenue and may soon replace the stretch IRA with a 5-year rule: Instead of extending distributions from inherited IRAs over a beneficiary’s lifetime, the beneficiary will have to withdraw the entire inherited IRA by the end of the 5th year after the year of the IRA owner’s death. This will diminish the long-term benefits of leaving an IRA or a Roth IRA to beneficiaries.
Now is the time to help clients plan to replace the stretch IRA with something even better — life insurance. Life insurance has three huge advantages over the stretch IRA:
1 — Life insurance distributions to beneficiaries are tax-free
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Though an inherited IRA can be stretched, the distributions will generally be taxable. Though inherited Roth IRA distributions will generally be tax-free to beneficiaries, the Roth IRA is paid for using funds that could be better leveraged for life insurance instead. Taking taxes out of the picture gives beneficiaries more leeway with distributions.
2 — Life insurance is not subject to required minimum distribution (RMD) rules
Inherited IRAs are subject to RMDs (whether the beneficiary needs the funds or not), forcing distributions out of the inherited tax-sheltered account. In addition, calculating RMDs on inherited IRAs can be challenging for beneficiaries and can result in penalties if the right RMD is not taken.
3 — Life insurance is not buried with complicated tax rules
Inherited IRAs are subject to confusing and tricky tax rules that make it more likely that an IRA beneficiary will blow the stretch IRA and end up with a tax problem instead.
Moving inherited IRA funds incorrectly can cause the account to be taxable because a non-spouse IRA beneficiary cannot do a rollover, but most beneficiaries do not know this.
Inherited IRA funds cannot be rolled over into a beneficiary’s own IRA. That would be treated as a distribution triggering premature income taxes and ending the inherited IRA. Beneficiaries are generally not aware of these tax traps until it is too late. There are also special tax rules for inherited IRAs that depend on who the beneficiary is. There are rules that apply to a spouse and those that apply to a non-spouse beneficiary. That creates different planning scenarios, which can lead to more tax mistakes if the rules are not followed precisely.
If clients want to ensure an inherited IRA is not squandered by beneficiaries, they would usually have to set up a trust and make that trust the IRA beneficiary and include restrictive provisions. But this is expensive to set up; and many of these trusts backfire because they don’t adhere to the tax rules that apply when an IRA is left to a trust. Even if the trust is done perfectly, it still can result in ultra-high taxes on the IRA distributions that end up being taxed in the trust.