Over the years, we lauded the stretch IRA as one of our favorite tax-saving moves, to help mitigate the tax bill when nonspouse heirs inherit retirement accounts and build wealth for another generation. But all good things come to an end—starting this year, nonspouse heirs who inherit IRAs are out of luck when it comes to using the stretch. The SECURE Act, signed into law in late 2019, mandates that many nonspouse heirs who receive inherited retirement accounts must empty the accounts within a decade.
The stretch strategy, which gave nonspouse heirs the opportunity to take out inherited IRA distributions over their own life expectancies, was targeted by Congress as a loophole used by the wealthy. In reality, the strategy was also used by those people who just diligently saved in retirement accounts for years and wanted to pass on as much of the legacy as possible to their progeny.
Albeit not a perfect strategy, spreading out the tax bill through the stretched distributions kept heirs’ tax tabs in check and allowed more of the money to grow for a longer time. The younger the beneficiary, the more advantageous the stretch could be.
After wiping away the tears over the stretch IRA’s demise, it’s time to get down to brass tacks and search for alternative options to the stretch. Don’t assume your only option is to accept Uncle Sam’s forced accelerated payout schedule. There are still moves that IRA owners can make to help ease the transfer of their legacy to their chosen beneficiaries and save some money from the taxman.
None of the alternatives are quite as cheap—read “free”—as the stretch strategy was, but we’ll start with the cheaper options and move into some that will require more thought and expense. As the new rules get fully digested, more alternate strategies could crop up. But the alternate strategies we look at here offer attractive opportunities to make the most of inherited IRAs under the new rules.
One critical point: Anyone who inherited an IRA before 2020 can stop reading. They need not worry about the new rules as nothing changes for them.
Pre-2020 nonspouse heirs can keep using the stretch strategy as it previously existed, and they can keep taking required minimum distributions based on their life expectancies from inherited IRAs.
But people who inherit IRAs starting in 2020 and beyond are subject to the new rules. And the new rules can shrink the legacy left to your heirs, as the online calculator at securermd.com illustrates. Let’s say a 55-year-old heir receives a $1 million inherited traditional IRA, the money grows 6% a year, and the heir takes distributions every year for 10 years. (You can use the calculator to plug in your own numbers to compare.)
Under the old stretch rules, in year 10, the nonspouse heir would take an RMD of about $57,000 and would have nearly $1.2 million left in the inherited IRA; he would have taken out about $445,000 in RMDs over the decade.
Under the new accelerated payout rules, in year 10, the heir zeroes out the inherited IRA as required with his last distribution of nearly $169,000 and would have taken more than $1.3 million in RMDs.
The heir who got to use the old stretch rules has about $331,000 more in total in year 10 with the combination of the total RMDs taken and the amount still left in the inherited IRA. The heir using the new rules not only has less money in total, but tops that off with a whopping $855,000 more in taxable RMD income by the end of the decade.
Clearly, there’s a cost for nonspouse IRA heirs who have lost the stretch. If you want more of your IRA to go to your heirs instead of Uncle Sam, here are some of the best alternative tax-advantaged strategies available now to IRA owners who are adjusting their estate plans for their families.
Carefully Mull Beneficiaries
As the SECURE Act swept away the stretch for many nonspouse heirs, the new law also created a new type of beneficiary: the eligible designated beneficiary. These beneficiaries “can still use the stretch rules as they previously existed,” says Lisa Featherngill, a certified public accountant and member of the American Institute of CPAs Personal Financial Planning Executive Committee.
If a named heir is a minor, disabled, chronically ill or not more than 10 years younger than the deceased owner, the heir qualifies as an eligible designated beneficiary. For instance, if the IRA owner has named a sibling two years younger as a beneficiary, that sibling could use the old stretch rules if she inherits the IRA, says Nancy Anderson, senior vice president and the head of wealth strategy and trust services at Calamos Wealth Management.
Note that only minors who are children of the deceased IRA owner fall in this EBD group, and once the minor reaches age of majority (18 or 21, depending on the state), the 10-year rule kicks in. Minor grandkids, once a popular choice to be named as IRA beneficiaries because of their long life expectancies, are immediately stuck with the new 10-year payout rule.
Also in this category: surviving spouses. They also aren’t subject to the new rules; but unlike any other beneficiaries, surviving spouses can take an inherited IRA as their own. That flexibility for widows and widowers hasn’t changed under the new law.
As you consider who should get your IRA, “look at those beneficiaries and see who might have an exception to the rules,” says Christine Russell, senior manager of retirement and annuities at TD Ameritrade. If you have potential heirs who fall into this new category of eligible designated beneficiaries, you might consider naming one of them as a beneficiary of your IRA since they can make use of the old stretch rules.
When mulling beneficiaries, you might also consider the tax situation of your heirs. Say you have two children, one who has a high-paying job and the other who is barely scraping by. You might want to leave a taxable traditional IRA to the one in the lower income-tax bracket, while leaving a Roth IRA or highly appreciated stock to the child in the higher tax bracket.
Bequeath Other Assets
While under the old rules you might have wanted to preserve your IRA to pass on to your heirs to do the stretch, it could be worth rethinking such a plan. If you are in a lower tax bracket than your nonspouse heirs, you might want to spend down your IRA and preserve other assets for your beneficiaries, such as highly appreciated stock or real estate, or Roth accounts.
Heirs who inherit capital assets, such as stock and real estate, that have appreciated will get a step up in basis to the assets’ value on the date of your death. Only appreciation after that date will be taxed if and when the heirs sell the asset. The higher basis would reduce the heirs’ tax hit.
Heirs to Roth IRAs still have to empty the accounts out within 10 years under the new rules, but the money distributed out of Roths is tax-free to heirs. “For heirs, it’s better to get a Roth,” says Anderson.
Do Roth Conversions
Speaking of Roths, one of the top strategies to consider is converting a traditional IRA to a Roth, says Jamie Hopkins, director of retirement research at the Carson Group. Heirs cannot do this conversion when they receive an inherited IRA; you must do the Roth conversion yourself while you’re still alive and kicking. You essentially prepay the tax bill for your heirs, giving them the gift of a tax-free pot of assets.
Most taxpayers likely want to convert an IRA to a Roth over time in smaller chunks to keep the tax bill they pay in check. Anytime you do a Roth conversion, you create taxable income that gets added to the rest of your taxable income for the year. Do too big of a Roth conversion and you could spike yourself into too high of a tax bracket unnecessarily. But as Hopkins notes, “tax rates are historically low,” which makes doing Roth conversions more attractive. Current income-tax rates are scheduled to last until 2026.
Also, compare your tax rate with the rates of your heirs. If your rate is lower than their rates, or you think your current rate will be lower than their future rates, then it can make sense to convert more now. If your heirs are in a lower tax bracket, then you might want to convert less.
Any amount you convert from a traditional IRA to a Roth IRA starts growing tax-free from the moment it goes into the Roth. So the sooner you get money into a Roth, the longer it will have to grow.
Maximize the New 10-Year Rule
A key point: The new 10-year withdrawal rule does not require that heirs take minimum distributions each of those years, but instead it only requires that all money be out of the account by the end of the tenth year following the year the IRA owner dies. That fact makes inheriting a Roth even more compelling.
Heirs who inherit a Roth IRA could leave the money alone for nearly 11 years to grow tax free. And in the last year, they can take out the entire lump sum with no tax consequence. A pretty sweet deal.
On the flip side, even though it’s not required, heirs who inherit a traditional IRA might want to take out some of the money each year to spread the tax bill, which might also spare some of the dollars from Uncle Sam. If an heir inherits a $500,000 traditional IRA, he could take $50,000 each year over the decade, rather than taking out the whole $500,000 in the last year. Spreading the distributions could result in a smaller total tax bill. How much smaller will depend on how much taxable income the heir has of his own in each of those years. The taxable windfall could subject the rest of the heir’s taxable income to a higher tax rate.
Heirs will have to look at their own tax situation when deciding how to take the money out in that decade. If the heir expects less taxable income of his own in a couple of those years—say, he’s going back to school to change careers—then those years might be a good time to take out more from the inherited IRA. If the heir expects more taxable income in a particular year, perhaps a big work bonus, that might be a year to skip taking money from the inherited IRA. “Heirs will need to do multiple years of tax planning and do some tax bracket management,” says Featherngill.
Reorganize Who’s Primary
Another way couples can maximize the 10-year rule: Consider naming other heirs as primary beneficiaries along with your spouse. “The answer in the past would be to roll [the IRA] to the spouse,” says Hopkins. But now, he notes, that won’t always be the clear choice.
Let’s say you planned to leave your IRA to your wife as the primary beneficiary and to your three kids as contingent beneficiaries. At your death, your surviving wife would get your IRA, avoiding the 10-year rule, and she takes your IRA as her own. The three kids eventually inherit her IRA money, which includes yours, and they each have 10 years to distribute their shares.
Instead, you might consider naming your wife and your three kids as primary beneficiaries. Assuming you split the IRA evenly, your surviving wife would get one-fourth to take as her own, while each of the three kids would get 10 years to distribute their shares of your IRA. When your wife passes away and leaves her IRA to the three kids, each of the three kids gets another 10 years to take that money. The kids could potentially get up to 20 years to take IRA money that was initially yours. “A solid strategy now is to have multiple primary beneficiaries,” says Russell.
Give IRA Money to Charity
If you are charitably inclined, the new 10-year payout requirement could make it more attractive for you to leave a traditional IRA to charity, says Featherngill. You can name charities as beneficiaries of your IRA, and the charity won’t pay tax on any of the traditional IRA money it receives.
You might also want to do charitable giving from an IRA now and leave more money in other assets to heirs, says Keith Bernhardt, vice president of retirement income for Fidelity Investments. The qualified charitable distribution might be more appealing—this move lets IRA owners age 70½ and older give up to $100,000 to charity directly from their IRAs each year. The money won’t show up in your adjusted gross income, and once you’re subject to RMDs at age 72, the QCD can count toward the RMD, too. The QCDs will lower your traditional IRA balance, which means heirs would receive less taxable income.
Create a Charitable Remainder Trust
This is another option for the charitably inclined, which can simulate the stretch IRA, says Brian Ellenbecker, senior financial planner at financial-services firm Baird. With a charitable remainder trust, you put assets in the trust and provide income for beneficiaries for a set term or for life. At the trust’s end, the remainder of the principal goes to charity.
You can use the trust to provide a stream of income to beneficiaries much like the stretch IRA was able to do. And for the charitably inclined, this trust meets the goal of transferring money to a good cause, too.
Anytime a trust is involved, though, there will be costs, including setup costs, fees to hire an estate-planning lawyer and possibly ongoing maintenance costs. And don’t forget to have old trusts looked at in light of the new law: Have a professional review any existing trusts you have that incorporate the stretch strategy, which may need language changes to accommodate the new law. “Most have to be revised or redone,” says Ellenbecker.
An old trust that uses language referring to RMDs could create unintended consequences, because now heirs aren’t required to take money out annually—only by the end of the 10th year. “It’s a one-year distribution,” says Hopkins. An old trust with RMD language could trigger an entire taxable payout—a disaster in terms of estate planning.
Use Life Insurance
Another possible, though also costly, option: life insurance. You could use distributions from your IRA, such as RMDs, to pay for premiums for a life insurance policy. At your death, the policy would provide income-tax-free death proceeds to your beneficiaries. Your IRA that passes to your heirs would also have a lower balance, as the money shifted to pay insurance premiums.
You could also reduce your gross estate by setting up an irrevocable life insurance trust to hold the policy. The trust would have costs of its own, but if you are worried about estate taxes, an ILIT removes the policy from your estate.
Life insurance can be an effective way to transfer wealth, but it comes at the cost of the insurance premiums—which can be more expensive if you implement this strategy later in life. “That premium wouldn’t be cheap, and you would need to be insurable,” says Michael Roberts, president of Arden Trust Co.
You must be healthy enough to be underwritten for a life insurance policy—and to get a better deal on the premiums. If premiums are too expensive, this option might not make sense.
If the life insurance strategy does work for you, you could pair it with the charitable remainder trust strategy. You could buy enough life insurance to provide a similar amount of proceeds to go to your heirs as the amount that will go to the charity at the end of the charitable remainder trust.
Any one of these alternate strategies might work for your family, or perhaps a combination of them. Although Uncle Sam surely won’t mind taking a bigger cut of your IRA assets, these strategies can help preserve more of your legacy to pass on to the next generation of your family. And from many Kiplinger’s Retirement Report readers I’ve heard from regarding this change in IRA rules, that is a top priority.
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