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The Stretch IRA is about to be killed, and that might be good for many people. It forces them to focus on other strategies that could increase their families’ financial security and increase after-tax wealth.
The Stretch IRA isn’t really a different type of IRA. It’s a strategy to be used by people who inherit IRAs as beneficiaries. The goal of the IRA is to make the IRA last as long as possible to take advantage of its tax-deferred compounding of income and gains. To accomplish this, the beneficiary of the IRA has as little distributed from the IRA each year as possible. In the ideal situation, the investment returns exceed the distributions each year, so the IRA balance increases over time. The beneficiary ultimately can use the IRA balance to help finance his or her own retirement or to pay for a substantial expense later in life.
Not everyone wants a Stretch IRA. Most IRA owners anticipate needing most of the IRA to fund their retirements. Most beneficiaries believe an inherited IRA is best-used to pay debt, improve a home or finance some other pressing need immediately after the IRA is inherited.
The Stretch IRA is a goal of people who have enough assets and income outside their IRAs to finance most of their retirement expenses. They plan to take only required minimum distributions (RMDs) from their traditional IRAs. They view the IRAs as sources of emergency funds and assets to be left to their children or other heirs.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act changes this strategy. The SECURE Act passed the House of Representatives by a wide margin in May but was stalled in the Senate. This week it is rolling through Congress after being attached to a spending bill that has to pass to prevent a government shutdown.
The SECURE Act has a large number of provisions. I focus on one in this post.
One provision of the SECURE Act abolishes the Stretch IRA. When an IRA is inherited, the beneficiary has to distribute the entire IRA within 10 years. That means the IRA has to be fully taxed within 10 years and the tax-deferred compounding ends. Though I refer to the Stretch IRA, the change also applies to 401(k) plans. The change even applies to Roth IRAs. Congress wants that money out of the tax-advantaged IRAs and subject to taxes. With the Roth IRA, future investment returns would be taxed.
There are some exceptions. The 10-year distribution requirement doesn’t apply to a beneficiary who is a surviving spouse, disabled person, a chronically ill person, a minor child or someone fewer than 10 years younger than the original IRA owner.
The end of the Stretch IRA applies to the IRA of any person who passes away after December 31, 2019. That doesn’t give people much time to implement alternatives to the Stretch IRA. Fortunately, there are alternatives that have been known for years. Most people didn’t bother to implement them, but they sometimes deliver better results than the Stretch IRA.
There were several disadvantages to the Stretch IRA.
One disadvantage is the original IRA owner has a lack of control or influence over the disposition of the IRA. You might intend for the balance to benefit the heirs in the future, but they might have other plans.
Most IRA beneficiaries distribute and spend IRAs within a few years after inheriting them. I’m aware of some who spent the money without realizing it was taxable and had to scramble to find money to pay the taxes.
That’s the second disadvantage of the Stretch IRA. An IRA isn’t treated like most other inherited assets. Distributions from an inherited IRA are taxed to the beneficiary just as they would have been taxed to the original owner. Distributions from an inherited traditional IRA are taxed as ordinary income at the beneficiary’s tax rate. In effect, a beneficiary is inheriting only the after-tax value of the IRA.
When you don’t plan to use most of a traditional IRA during your lifetime, there might be better strategies than to keep the money in the IRA. For example, you can distribute the money, pay the taxes and invest the after-tax balance. One advantage is the portfolio can be managed to avoid ordinary income taxes on the income and gains. Instead, the earnings could be tax-advantaged long-term gains and qualified dividends. You also could use any losses to offset gains to minimize taxes. You could have a higher after-tax return by investing the money outside the IRA. The earlier you start this strategy, the more the lower taxes over the years offset the cost of paying the taxes early by taking a distribution from the IRA.
Another benefit of the strategy is that when your heirs inherit the assets, they increase the tax basis of any appreciated assets to their current fair market value. When you buy and hold stocks, mutual funds or other investments, the gains that accrued during your lifetime never face capital gains taxes.
A second strategy was explained to me by David Phillips of Phillips Financial Services of Gilbert, Ariz. He calls it the IRA Leverage Strategy. It’s best explained with an example.
Suppose Max and Rosie Profits are age 71. Max has a $1 million traditional IRA. They don’t need the IRA to fund their retirement, and Max soon will have to take RMDs.
The Profits form a trust with their two children as beneficiaries. Max and Rosie transfer the annual RMDs to the trust. There are no gift and estate taxes because of the annual gift tax exclusion, which is $15,000 in 2019 and 2020. The trust takes out a joint and survivor life insurance policy on Max and Rosie, naming the trust as beneficiary. Because of their ages and good health, the policy benefit is more than $1.4 million.
Max and Rosie use the RMDs to make annual gifts to the trust that are used to pay the premiums. After Max and Rosie pass away, no matter when that is, the insurance company will pay at least $1.4 million to the trust, and the trust will use it for the beneficiaries or distribute it to them as called for in the trust agreement. The life insurance benefit is tax free to the trust and also tax free when distributed to the beneficiaries. The children also receive any amount that’s left in the Profits’ IRA.
The life insurance guarantees the trust receives more than currently is in the IRA. The amount the trust eventually receives doesn’t change with market fluctuations. Max and Rosie can draft the trust agreement to direct when distributions will be made to their children.
The details depend on individual circumstances and the type of policy purchased. There are other strategies worth considering, some of which involve life insurance or charitable trusts. I’ll discuss them in future posts.
When the Stretch IRA was part of your retirement and estate plan, it’s time to revise your plan. The SECURE Act takes away the Stretch IRA and forces you to consider alternatives.