Alternatives to the “Strecth IRA” Outlawed by Secure Act

After the original SECURE Act was signed into law, clients and advisors quickly realized that the inherited IRA had lost a key quality: the ability for beneficiaries to stretch the associated tax liability over their lifetime. The IRS further limited the tax deferral benefit by releasing proposed regulations that require beneficiaries to take taxable distributions each year. Now, many clients are searching for alternatives to the so-called “stretch” IRA. Estate planning alternatives do exist—but each comes with its own set of complications that clients must understand before taking action.

The Inherited IRA Post-SECURE Act: Background

Before the SECURE Act became law, inherited IRA beneficiaries could stretch the tax liability associated with these accounts over their own life expectancy. Post-SECURE, only eligible designated beneficiaries (EDBs) have that option. EDBs include (1) surviving spouses, (2) disabled or chronically ill beneficiaries, (3) beneficiaries who are not more than ten years younger than the original IRA owner and (4) the original IRA owner’s minor children (until they reach age 21).

All other beneficiaries must empty the account within ten years of the original IRA owner’s death (paying ordinary income taxes on those distributions). Before the IRS released proposed regulations, most experts believed that beneficiaries wouldn’t have to take RMDs during the first nine years, leaving the option of deferring all taxes until year 10.

A surprise twist in the new regulations changed that rule for beneficiaries of IRAs where the original owner died after his or her required beginning date (the date RMDs began). Those beneficiaries are also required to take annual RMDs during years 1-9 after the original IRA owner’s death. Any remaining amounts must be distributed in year 10.

The Roth Conversion Option

The new regulations make Roth conversions even more appealing for beneficiaries. However, the SECURE Act also modified the rules governing inherited Roth IRAs. Those beneficiaries will now be required to empty the account in ten years if they do not qualify as an EDB.

Roth IRAs are still appealing despite the change because Roth IRAs are not subject to RMD rules during the original IRA owner’s life. Roth IRA beneficiaries must take RMDs after the original owner’s death—but that owner will always be deemed to have died before their required beginning date because a Roth can never go into pay status because there is no required beginning date. That’s because the original owner didn’t have to take RMDs during life in the first place.

In other words, any Roth IRA beneficiary can wait until year ten to empty the account—allowing the funds to grow tax-deferred for another ten years. Of course, those funds are nontaxable because the original account owner paid taxes on Roth contributions during life, but the earnings will be tax-free as well.

It’s possible to minimize the original owner’s tax liability by executing Roth conversions after retirement, when the taxpayer may have entered a lower income tax bracket. However, clients will want to pay close attention to proposed changes that could limit the availability of Roth conversions for higher-income taxpayers in future years.

The Charitable Remainder Trust Option

Clients might also consider establishing a charitable remainder trust (CRT) and naming the CRT as their IRA beneficiary.

The CRT is an irrevocable trust that will provide income to the beneficiary each year, whether for life or over a predetermined term of years. The amount of income received is based on the value of the assets the client has passed to the CRT (the amount is re-calculated each year). At the end of the term, the remaining account value is paid to a qualified U.S. charity (the CRT must be structured so that the charity receives at least 10% of the donor’s contribution).

The account owner’s estate will receive an estate tax deduction for the charitable gift. The CRT distributions to beneficiaries are taxed as ordinary income. On the other hand, using the CRT to distribute funds over the beneficiary’s lifetime gives the assets more time to grow, so that the heir’s overall inheritance may be larger in the end.

Conclusion

Pre-SECURE Act, clients could rest assured knowing that if they failed to empty their IRAs during life, their beneficiaries would gain the added benefit of a tax-preferred inheritance. Now, higher income clients should consider alternatives if they had planned to access non-IRA funds to fund their retirement costs with the expectation of leaving a sizeable balance behind.

Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.