How the SECURE Act Impacts Inherited IRAs
Last week, we published an article summarizing many of the changes the SECURE Act brings to retirement plans. These include new rules regarding retirement plan contributions, distributions, the availability of annuities within plans, maximum contributions for automatic enrollment plans, employer incentives to participate, and more.
This week, we focus on one remaining change—and perhaps biggest challenge—of the SECURE Act: the new rules around inherited IRAs. The stretch IRA strategy is dead and it’s time to seek alternatives. If you believe you may inherit an IRA or leave one to beneficiaries, this is information you need now—before it’s too late to stop Uncle Sam from taking a big chunk of your intended inheritance!
“The Worst Asset to Die With”
I have said before, “An IRA is the worst asset to die with.” A traditional inherited IRA or 401(k) has always been taxable at income tax rates and subjected to government rules and restrictions. For instance, if you decide you want to buy real estate in your IRA, it will affect your financing, restrict your use of the property, and prevent you from doing your own repairs even if you are qualified to do so. (See “5 Assets that Don’t Belong in Your Retirement Account.”)
Well, thanks to the SECURE Act, inherited IRAs are now an even worse asset to leave to heirs! That’s because new rules will give Uncle Sam a bigger cut of the money intended for beneficiaries.
Under the new law, most beneficiaries of inherited IRAs must withdraw all assets within 10 years of the owner’s death. For beneficiaries approaching their maximum earning potential (around age 50, statistically speaking), this means that IRA distributions must be taken when income—and tax brackets—are at a high point.
Before the Secure Act, the required minimum distribution (RMD) rules allowed a non-spouse beneficiary to gradually drain the substantial IRA inherited from a parent or grandparent over their IRS-defined life expectancy. Now, the “stretch IRA,” as it is referred to, is only available to spouses and very specific individuals.
The new 10-year distribution rule is good for the government, which will receive more in taxes. According to the Congressional Research Service, eliminating the stretch IRA alone has the potential to generate about $15.7 billion in tax revenue over the next decade. No more pesky long-term deferrals that require Uncle Sam to keep waiting for his share!
Unfortunately, for those with considerable balances in their retirement accounts, the new law represents a potential tax disaster and a loss of control for both the current IRA owner and future beneficiaries. While the new legislation brought several positive changes, this change will frustrate estate planners for years to come and should motivate many to adjust their strategy—or even save elsewhere.
The End of the Stretch IRA?
“Stretch IRA” is simply the nickname for the strategy of sheltering or minimizing inherited income from taxes for as long as possible by “stretching” distributions out as long as possible. (It is not the name of a particular type of IRA.) The strategy was especially useful when making younger generations (even grandchildren or great grandchildren) beneficiaries of an account. By taking required minimum distributions (RMDs) over as long a period as possible—calculated according to the life expectancy of beneficiary—the stretch IRA strategy allowed for:
- Minimal required distributions and more control over when the beneficiary withdraws money from the IRA. (Of course, you can never withdraw less than the RMD).
- Maximum growth of investments inside the IRA, which can increase the size of the inheritance.
- Fewer taxes paid for large inheritances by spreading out distributions and minimizing tax brackets.
- A higher chance of leaving a future inheritance to “next generation” beneficiaries, as an IRA could be passed down more than once.
- And when used with a Roth IRA—which prior to the SECURE Act, required no RMDs—beneficiaries could enjoy tax-free growth and tax-free withdrawals for an indefinite period of time.
Bottom line: the stretch IRA method was the most tax-efficient way to pass a retirement account to heirs. But with the passage of the new law, the strategy can no longer be used when the original account holder dies after Dec. 31, 2019. (The old rules prevail for spouses and for beneficiaries already in possession of inherited IRAs.)
Exceptions to the 10-Year Rule
The SECURE Act’s required minimum distribution (RMD) changes will not affect accounts inherited by a so-called “eligible designated beneficiary.” The Act defines an eligible designated beneficiary as one of the following:
- The surviving spouse of the deceased account owner.
- A minor child of the deceased account owner.
- A beneficiary who is no more than 10 years younger than the deceased account owner. (For instance, a sibling 7 years younger than the deceased account owner).
- A disabled or chronically-ill individual (as defined by the law).
Obviously, those are important exceptions. But it also means that if one spouse leaves a large IRA to the other, the surviving spouse must either spend it down or leave it to heirs who will have to drain the account within 10 years (unless the new beneficiary is also an “eligible designated beneficiary”).
Disadvantages of the Drain-in-10 Rule
One potential challenge of the 10-year rule is with minor children who are beneficiaries of an inherited IRA. While the exception applies to children, when the minor turns 18, the ten-year clock begins. If the account holder intended for the beneficiary to receive the money over a longer-time frame or at an older age, it’s time to re-think using an IRA to do so.
A related challenge of the 10-year rule is that it can skew or supersede the intentions of a pre-existing trust. An IRA account holder might have an inheritance set up through a “pass through” trust that dictates that the beneficiary can only receive the required minimum distribution (and no more) each year. This protects the beneficiary from withdrawing more money than they know how to manage, potentially wasting it. In the past, the original owners of the IRA could use a trust to limit the flow of money if the beneficiary was a young adult or a spendthrift.
However, the Secure Act, requires NO minimum distributions for inherited IRAs. It only requires that all of the money is taken out within 10 years. (These rules also apply to inherited 401(k) accounts as well as Roth IRAs.) What this means is that, technically speaking, there is no required minimum distribution until the end of the tenth year. At that time, the remaining balance—the entire account—must be withdrawn and the account closed, regardless of the tax consequences.
Examples of how the 10-year rule impacts inherited IRAs.
George leaves a $750,000 IRA to his granddaughter Irene, age 43. Irene is a successful realtor who earns around $160k per year. She only has ten years to take the entire amount through withdrawals, which will be taxed as ordinary income. At current tax rates and brackets, that means she will be paying a 32 percent tax rate on the inherited dollars, not the 24 percent tax rate which is currently her top tier. Grandpa George didn’t intend to leave so much to Uncle Sam!
Or consider Grandma Betsy, who leaves a $600,000 IRA to her grandsons, ages 15 and 19. Since the 19-year-old is considered an adult, he must take the entire amount no later than 10 years. The same 10-year-clock starts ticking for the 15-year old as soon as he turns 18. Although Betsy’s will and trust specify certain conditions for receiving the money and a longer time frame, the trustee cannot delay the distribution of this entire account to the young men beyond the ages of 28 and 39. Hopefully, they will be ready for it!
At age 85, Alexander left a Roth IRA to his wife, Carole, age 72, and a traditional IRA to his younger brother, William, age 77. Since Carol was his spouse and William was no more than ten years younger, both are eligible designated beneficiaries and neither are subject to the drain-in-10 rule. (Note: it gets more complicated and problematic if you leave one IRA to multiple beneficiaries. Consult your estate planner or tax advisor about the implications.)
Jack and Judy, age 75 and 77, are still alive and well. Since they have other assets with healthy cash flow, they both intended to leave their Roth IRAs (currently valued at $350,000 apiece) to their children as a long-term “family bank” to fund college educations and home down payments, potentially for generations to come. They even have a trust detailing how the money is to be used.
Under the old rules, the Roth IRA could have grown tax-free with no minimum distributions required—ever. However, the Roth’s long-term tax-advantaged deal for heirs is gone with the SECURE Act. Beneficiaries of Roth accounts must also withdraw all monies within 10 years, even though they will not pay taxes under current law.
Stretch IRA Alternatives to Consider
There are several strategies you can employ to avoid forcing beneficiaries to withdraw and pay taxes on retirement account disbursements within a 10 year period. A combination of some of the following strategies can help you avoid the impact of the 10-year rule altogether.
#1: Draw down your IRA before other assets in retirement.
If you sequence how you spend your assets in retirement, this can save YOU a significant amount on taxes as well as your heirs! The secret is spending down the LEAST tax-efficient assets first. This includes your IRA. Then use other assets such as life insurance, real estate, bridge loans and annuities for cash flow in retirement.
Don’t need the income from your IRA? With the new rules and the death of the stretch IRA, you might consider drawing down your retirement accounts and reinvest elsewhere. Real estate and oil and gas investments provide substantial tax benefits, and you’ll have more control over these assets outside of an IRA.
When it comes to leaving an inheritance, you’ll have more control over the disbursement of virtually any asset outside of a qualified retirement plan. An IRA is a poor substitute for a trust that you control.
#2: Use life insurance—not retirement accounts—to pass assets to the next generation.
Life insurance is the most efficient way to pass assets to heirs. After all, this is what life insurance is designed to do! When you obtain a permanent whole life insurance policy and keep it in force, you can usually transfer an inheritance completely tax-free. (Estate taxes, if applicable, may apply for those over the exemption limit.)
You could fund a life insurance through distributions from your IRA (taxable unless a Roth). This move, in effect, takes money out of your IRA and puts it in an environment where it can grow and multiply (usually) tax-free. Other options for funding a life insurance policy include:
- income from cash-flowing real estate investments
- income from bridge loans or other private lending investments (inside or outside your IRA), or
- cash flow from an annuity (preferably a SPIA—single premium immediate annuity—obtained at age 70 or beyond).
If you are still working and contributing to your IRA, consider diverting some of the money used for contributions into whole life premiums instead. Not only can it be a more efficient way to grow and transfer an inheritance, it will also create cash and liquidity that you can use for any reason—including starting a business or investing in bridge loans or real estate! Plus, the guarantees of whole life can bring certainty and stability to your portfolio.
Life insurance solves another problem with inherited IRAs. If you have younger heirs or reasons to want to control how much or how fast an inheritance is disbursed, make a trust the beneficiary of your policy and you have nearly unlimited control and options.
Whole life insurance also has tremendous flexibility and potential for living benefits and/or cash flow down the road. For instance, you could annuitize a portion of your policy in your later years and still leave something for heirs. Or you may desire a chronic or terminal illness rider that would protect your other assets by allowing you to use a portion of your own death benefit in the event of certain diagnoses.
#3: Consider a Charitable Remainder Trust
A charitable remainder trust, or CRT, can fulfill several aims at once. By making a CRT the beneficiary of an IRA, the account holder/donor can:
- reduce taxes
- benefit a charity
- and provide long-term income to non-spouse beneficiary.
In this scenario, the account owner creates and funds the CRT with IRA assets at death. Typically, those assets are used to purchase an annuity which then provides beneficiaries a regular income stream, similar to the required minimum distributions from an inherited IRA. That income can be distributed over a certain length of time or the beneficiary’s lifetime.
The IRA pays no income taxes when its assets are distributed to the trust because the assets ultimately benefit a non-profit. A tax deduction can be claimed by the estate of the original IRA account owner who created the CRT. The assets from a CRT is taxed when it leaves the trust in the form of distributions, but as this period is not limited to 10 years, the beneficiary can benefit.
Finally, when the beneficiary dies or the term of the trust expires, the trust’s remaining assets go to the designated charity tax-free. A CRT can be used in conjunction with life insurance to ensure that the beneficiaries receive the full amount of the original asset. This can be a real win-win as the charity also benefits!
#4 Start funding a Roth instead of your traditional 401(k) or IRA.
While the new law may cause some to look at a Roth conversion, the tax bill required in such a move is often formidable. However, if you are still working and contributing, consider if it makes sense to shift the type of account you are funding.
While the Roth IRA is also now subject to the “drain in 10” rule, on the plus side, distributions to beneficiaries will not be taxed. (Of course, this is under current law, which leads to an important observation…)
The Government Giveth, the Government Taketh Away
The virtual elimination of the stretch IRA highlights one of the big problems with government-sponsored retirement plans. You’re always playing by the government’s rules… and the rules can change.
Whenever you participate in a government-sponsored retirement plan, you lose a measure of control. A qualified retirement plan has been blessed by the government with tax advantages such as deferral of taxes and tax-free growth. However, the government has the power to repeal whatever rules it makes!
A long-term tax deferral from Uncle Sam for you and your heirs might sound great, but when Uncle Sam wants his money back, he can change the rules. This is why we favor Prosperity Economics philosophy and strategies. Prosperity Economics seeks to keep YOU—not your employer or the government—in control of your money.
by Kim Butler and Kate Phillips