For archival purposes only -- see Editor's Note at the bottom of this post.
Inherited IRAs, or “Stretch IRAs,” as we know them today could soon be history. There are two retirement bills floating through Congress that aim to overhaul America’s retirement system.
The first to be passed by the House of Representatives on Thursday, May 23rd, was the Secure Act, and there’s similar bill in the Senate called the “RESA” (Retirement Enhancement and Savings Act). Both bills would significantly change the retirement system in America, and both seek to pay for the expenses with revenue generated from pre-tax accounts changing hands from their Baby Boomer owners to their Gen X and Millennial non-spouse beneficiaries.
Stretching Inherited IRAs Is Not A Birthright
Recently, an advisor friend discovered, through a computer-aided design program, that his clients would never spend all their pre-tax retirement money and would have a significant surplus of pre-tax money to transfer to the next generation.
I suggested he approach the conversation of wealth transfer with his clients and have them consider a strategy where they repositioned some of that money into a life insurance policy to leave tax-free money to their heirs instead. Since they would be taking RMDs in a few years anyway, they could start then and fill up their current tax bracket with strategic distributions, using the proceeds to buy life insurance that might also double as a long-term care strategy.
My friend asked a good question in response — couldn’t the kids do an Inherited IRA and spread distributions and tax liability over their lifetime?
While that is the current law, I cautioned him that it might not always be the case — the good government giveth, and the good government taketh away. Ironically, this conversation took place on the heels of the Secure Act being passed by the House of Representatives, which contains language that would do away with Inherited IRAs as we know them today.
Brief History of the Stretch IRA
Many financial representatives are familiar with rules regarding Inherited or “Stretch” IRAs where a non-spouse beneficiary receives a pre-tax account as an inheritance and would currently have several choices of how they can claim it.
In short, beneficiaries are given the privilege of continuing to defer taxes if they keep the IRA in the name of the deceased owner. However, they are required to begin minimum distributions in the calendar year following the year of death of the original owner. These required distributions are based on the attained age of the non-spouse beneficiary. Much of this is common knowledge within the financial industry community.
However, few are as familiar with the history of Inherited IRAs as we know them today.
Prior to the TEFRA Act of 1982, there were no required distribution rules for tax deferred accounts. Because there were no required minimum distribution rules, it would have been realistic for non-spouse beneficiaries to continue deferment of taxable accounts indefinitely, and then pass them to their non-spouse beneficiaries, and so on.
However, the TEFRA Act of 1982 sought to change that. It would require that non-spouse beneficiaries of pre-tax accounts to distribute those inherited accounts over a period no longer than five years. Thus, accelerating the pace at which the government would be able to collect their tax money. Meaning, no more indefinite deferral!
But before the Act could go into effect, Congress passed the 1984 DEFRA Act, which established the rules around Inherited IRAs as we know them today.
The War on the Inherited IRA
There has been a plot against Inherited IRAs going on in Washington for nearly a decade. A cash- strapped Congress is always on the lookout for ways to generate revenue. Distributions from pre-tax accounts, like IRAs, which are taxed as ordinary income, are an attractive source of revenue in the eyes of many legislators. Swelling Baby Boomer retirement accounts over the past decade have not gone unnoticed, and there have been many attempts in recent years to eliminate the ability to stretch inherited accounts.
Several bills over the past decade have listed changes to Inherited IRAs as a possible way to pay for these pieces of legislation. To-date, all of them have died in committee or been gutted of their language that would alter rules regarding distributions from non-spouse inherited pre-tax accounts. And it seems the desire to make changes has not been forgotten and is hitting a fever pitch.
The Secure Act, which is primarily Democrat-supported is not the only change coming down the pipeline. The RESA Act in the Senate has similar intentions. The two parties may favor slightly different angles, but this demonstrates that the idea has bipartisan support. And there doesn’t appear to be anyone coming to the rescue of Inherited IRAs right as a massive amount of wealth is about to shift from Baby Boomers to their offspring.
A World Without Stretch IRAs
Imagine for a moment you have two clients who has done very well for themselves. They are well-educated, have had excellent careers, and have saved significantly more than they will ever need in order to maintain their desired lifestyle in retirement. Unfortunately, nearly all their wealth resides in pre-tax accounts.
Suppose they have two children, also both successful. Their children are married with dual incomes that place them in elevated tax brackets.
Under the new proposed legislation, these children may have to accelerate receipt of the inherited pre-tax dollars over a 5 to 10-year period, depending on what final legislation looks like.
If your clients passed with pre-tax accounts totaling $1 million that was to be split between two children, that could result in each child adding approximately $200,000 to an already high income, each year for five years.
Would that push them into a higher tax bracket? Quite possibly, and without the ability to take distributions over their lifetime, they may be forced into a situation where a significant portion of their own income is subject to a higher tax bracket because of the inheritance. Not to mention, a part of the inheritance could be lost to high taxes.
An Alternative Tax Efficient Wealth Transfer Plan
Many folks seem to think that the need for estate planning is less important today because of the higher estate tax laws. However, I would beg to differ. Considering the massive wealth transfer that is poised to happen with Baby Boomer pre-tax accounts, there’s good reason to talk to your clients about tax efficient wealth transfer planning.
It may make sense for your clients to start distributions earlier than required and pay taxes at their potential lower post-working tax rate. Then they might consider taking the after-tax proceeds and using it to purchase life insurance.
Baby Boomers might also be interested this option because many are caring for aging parents. They are acutely aware of special skills required to do this and are more open to the conversation about strategies that would help deal with a long-term care event — more-so, perhaps, than previous generations were. Will you be the one to introduce the idea?
Do You Need A New Strategy?
As an advisor, if your strategy up to this point has been to manage your client’s pre-tax dollars, and then watch it transfer to the next generation, expecting that their non-spouse beneficiaries will be able to continue tax deferment while they take distributions over their lifetime — it may be time to rethink this strategy. It’s very likely that in the near future, this will no longer be a planning option available to your clients’ non-spouse beneficiaries (a.k.a. their children and the grandchildren).
Editor's Note: Since the publishing of this blog post, the Setting Every Community Up for Retirement Enhancement Act (the “SECURE Act”) passed in the United States House of Representatives on May 23, 2019, and is now attached to a bipartisan appropriations bill that will help avert a government shutdown. With just a few weeks before the end of the year, the bill has passed the Senate. In effect as of January 1, 2020, the SECURE Act will be the most significant retirement legislation since the Pension Protection Act of 2006.
One of several measures included in the bill, will:
Remove the “stretch” provisions of inherited 401(k)s and IRAs. In the past, beneficiaries could spread distributions over their life expectancy. The SECURE Act would require most beneficiaries to take distributions over a 10-year period. This provision is viewed as a tax-generation provision.
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