Since their introduction in 1974, IRAs have become one of the most popular tools for retirement savings. And with an average of one out of three Americans now owning an IRA, they are also among the most significant assets addressed in many estate plans. Although funding retirement remains the primary purpose of an IRA, not everyone intends to use the entire balance during retirement. For these folks, efficiently transferring the remaining wealth in this account to heirs is a vital estate-planning goal.
Historically, the most tax-efficient strategy for managing an inherited retirement account has been to convert the account into a “Stretch IRA,” which lets the beneficiary gradually withdraw the balance over the duration of his or her life expectancy. However, with the advent of the Secure Act, Stretch IRAs may no longer be a viable option.
(Related: Secure Act Forcing Shift in IRA Planning)
The gist of the change brought about by the Secure Act is that Beneficiaries will now have to pay the income taxes due for distributions over a shorter period — often at a higher rate and without the benefit of additional growth earned during the longer period of deferral.
In response to the Secure Act, financial planners have scrambling to find alternative methods to get the same results previously achieved through Stretch IRAs. Specifically, the aim is to transfer IRA wealth to succeeding generations in a manner that is both tax-efficient and maximizes growth potential. Roth conversions and whole life insurance both show promise as potential substitutes, though of course no approach can be perfect for every situation. With that in mind, it’s a good idea to consult with an experienced financial planning expert before updating your estate plan.
What is a Stretch IRA?
In a nutshell, a Stretch IRA has been the go-to strategy for minimizing taxes on IRA distributions, for those who inherit these accounts, using an investment account funded with the proceeds of an inherited IRA. When an inherited account is converted into a Stretch, income taxes aren’t due on the inherited money until the funds are distributed — not at the time of inheritance. Under prior tax rules, a beneficiary could “stretch” account distributions over his or her entire lifetime (based on life expectancy at the time of inheritance).
Because a Stretch IRA allows for distributions over the longest possible timeframe, the required distributions are smaller. The smaller distributions equate to lower annual tax bills and, in many cases, a lower effective rate for the aggregate distributions. And, more importantly, the longer the income taxes are deferred, the longer the earnings within the account can continue compounding.
The multi-generational deferred growth facilitated by a Stretch IRA can lead to long-term wealth accrual exponentially larger than if the taxes are paid at the time of inheritance and then each year as the after-tax funds earn investment returns. Unfortunately, though, with the passage of the Secure Act, Stretch IRAs are headed for extinction.
What is the Secure Act?
The Setting Every Community Up for Retirement Enhancement (“SECURE”) Act became effective January 1, 2020. Although it does have a couple nice perks for retirement account-holders, the demise of Stretch IRAs embedded within the Secure Act led Forbes writer James Lange to label the new law the “Extreme Death-Tax for IRA and Retirement Plan Owners Act.” That’s pretty dramatic. But is it really all that bad?
Well, the law does push back the age at which retirees must start taking “required minimum distributions” (RMD). And it also allows account contributions later in life. These provisions allow for more flexibility and control when deciding how to utilize an IRA in a retirement plan. Pushing back RMDs also enables extended deferral of taxes prior to commencement of distributions.
So, the Secure Act has some decent features if you look only at the direct effects on IRA owners saving for retirement. It’s the next generation — individuals who inherit an existing IRA — who are going to pay the freight and suffer the negative consequences of the new law.
Under the new law, someone inheriting an IRA is now required to distribute the entire balance within ten years of the original owner’s death. So, beneficiaries must pay taxes on the inherited wealth within 10 years and can no longer “stretch” distributions over the remainder of their own lifetimes.
Remember, traditional IRAs and 401ks are funded with pre-tax money, which means that, when the funds are withdrawn, they are treated as taxable income to the recipient — whether that is the original owner or a beneficiary. If you opt to receive the money as a lump sum, all the taxes are due right away, usually pushing you up into a higher tax bracket and resulting in a greater overall tax bill.
By contrast, if you withdraw the money over time, you typically pay a lower effective rate. Crucially, the longer you defer distributions, the longer the money continues compounding within the account. Money that would otherwise be paid to the IRS instead remains invested and earning returns. And the returns earn more returns — all with no income tax liability until the money is actually withdrawn