Money Management Retirement Planning Tax Planning

Life After Stretch IRAs

Pending Legislation Could Affect Inherited IRAs in a Big Way

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, is 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 that I coach 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 begin right now 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?”

Under the current law, “yes” they can. However, 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 professionals 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 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 just as a massive amount of wealth is about to shift from Baby Boomers to their offspring.

A World Without Stretch IRAs

Imagine how this might impact a family like yours. You’ve done very well for yourselves. You have made good decisions with your career and your money, built a sustainable and enjoyable lifestyle, and likely saved more retirement assets than you need in order to maintain your desired lifestyle in retirement. Unfortunately, nearly all of your wealth resides in pre-tax accounts because you’ve been coached by your accountant, employer, and others to “save” taxes by contributing to a pre-tax account like a 401k or IRA.  

You know by now that you did not “save” taxes, but rather deferred them to a later date. Either you, or your beneficiaries, will pay taxes upon distributions from your pre-tax accounts. The distributions, forced by IRS Required Distributions rules, will result in income tax due at the next highest marginal tax rate. 

Suppose you have two children, also both successful. You made certain they were well educated, and your children were fortunate enough to find well educated and successful spouses to marry. Both children live in dual income households 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 you passed with pre-tax accounts totaling $1 million for example, to be split between your 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 large 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 recent changes to 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 about tax efficient wealth transfer planning.

It may make sense to start distributions earlier than required and pay taxes at a potentially lower tax rate after you are no longer fully employed. The after-tax proceeds could possibly be used to purchase federal income tax free dollars leveraging life insurance that pays at the passing of the surviving spouse. Ultimately, the government gets less of the money you worked hard to acquire, and your heirs keep more.

A New Dual-Purpose Strategy?

Boomer children caring for their aging parents may find this strategy interesting as well. They are acutely aware of special skills required to care for aging parents 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.

Many insurance companies have designed life insurance policies to address the everchanging needs of boomers entering their retirement years.

Unlike the past, you don’t have to die for a policy to have economic value for your family. 

Many policies available today serve a dual purpose:

  1. Leave tax free dollars as a wealth transfer strategy at the passing of the surviving spouse, and
  2. Create a pool of tax-free money that may be used to offset expenses associated with a long-term care event for either spouse.

If either spouse needs in home care, assisted living, or other skilled nursing services, the tax-free dollars designated for wealth transfer may be accessed to pay for the cost of care.

If either spouse is fortunate enough to not need care, the tax-free money passes to their heirs.

Some policies even give the right to terminate the policy, and receive some or all of the premiums back. These policy holders with either use it, die with it, or quit and receive some or all of their money back.

Taking Preventative Action

So, what do you do now? The ability to defer taxes on inherited pre-tax accounts may likely change soon. How soon? Perhaps before the end of 2019. Whether it is you inheriting a pre-tax account from your aging parents, or your children or grandchildren inheriting said accounts from you, taxes are inevitable.

Even if the RESA or SECURE acts are changed and inherited IRAs as we know them today are somehow spared again, it is only a matter of time. With so many potential tax dollars at stake, congress will be back time and again. It’s just too tempting!

Making plans now to be more tax efficient throughout retirement is a good place to start. Not just tax efficient in your first years of retirement, but rather creating tax equilibrium over decades through strategic planning. Next, prudently plan for life after Stretch IRAs, because they may not be here tomorrow. Developing a tax efficient wealth transfer strategy that may also double as a long term care strategy may be a great place to begin.  

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