Getting Around the Stretch IRA Block
Leaving behind a huge tax bill for your heirs with the stretch IRA scuttled? Here are some ways around it as lawmakers consider an updated SECURE Act.
Many seniors dream of helping to shore up a loved one's financial future by leaving a sizable inheritance after they die. But if retirees aren't careful, they could also end up leaving behind a hefty tax bill.
In December 2019, Congress passed the Setting Every Community Up for Retirement Enhancement Act, the biggest retirement-related legislation enacted in more than a decade, and some experts believe more reforms lie ahead (see SECURE Act 2.0: 10 Ways the Proposed Law Could Change Retirement Savings). Some of the changes from the 2019 law were positive. For instance, the age for taking required minimum distributions was raised to 72.
By far and away, however, the SECURE Act's most damaging legacy was the end of the stretch IRA, which upended carefully crafted estate plans to transfer retirement savings to the next generation. "We hear from a lot of clients that they don't necessarily need all of their RMDs to live off of," says Roger Young, a senior retirement insights manager at investment management firm T. Rowe Price in Baltimore. "Instead, they are looking to preserve those balances for their heirs."
Before the SECURE Act, heirs who inherited a traditional IRA could take required minimum distributions based on their own life expectancy, stretching out the time to withdraw the money and leaving more of it in the account to grow tax-free. The stretch IRA, as it came to be known, also meant a potentially lower tax bill because the withdrawals could be spread out over many years, keeping the beneficiary's taxable income in check. The rules were essentially the same for an inherited Roth IRA. Even though Roth IRAs do not have RMDs for the original owner, heirs were required to withdraw the funds based on their own life expectancy. The distributions, though, were tax-free as these accounts are funded with post-tax dollars.
Now, spouses who inherit a traditional or a Roth IRA can still use the stretch IRA, but the SECURE Act eliminated this option for most other heirs, who instead must empty the account within 10 years. Exceptions include heirs who are disabled or chronically ill or not more than 10 years younger than the original owner. An underage child of the original owner can also stretch out the IRA generally until the age of majority, when the 10-year rule kicks in. The new requirements apply to IRAs inherited after Dec. 31, 2019.
All of this has left Americans struggling to find the most tax-efficient ways to leave inheritances and replace the stretch IRA. "The impact the SECURE Act had on living people with their own retirement plans was incremental," says Mark Worthington, senior counsel at the Special Needs Law Group of Massachusetts in Farmington. "What happens when you die is where the changes were mind blowing."
Roth Conversions Take On New Importance
Although the elimination of the stretch IRA applied to both types of IRAs, it mostly created a problem for traditional IRAs. Unlike Roth accounts, withdrawals from traditional IRAs are taxed. Under the new 10-year rule for emptying the account, heirs can withdraw the funds anyway they like, whether as a lump sum or installments, and even vary the amounts taken out. From a tax perspective, an adult child inheriting, say, a $1 million traditional IRA from a parent will almost certainly be better off withdrawing some money each year, rather than taking one lump sum that is likely to push them into a much higher tax bracket, says Jonathan Howard, a financial planner with SeaCure Advisors in Lexington, Ky. But that also means there will be more time for the funds to continue to grow, forcing even larger withdrawals later. "That [IRA balance] could very easily become $1.5 million," he says.
To help their heirs dodge a big tax bill, many people are converting traditional IRAs to Roths. "The SECURE Act has brought Roth conversions into the conversation," Howard says. "More people are looking into that without financial planners having to instigate that conversation." Roth conversions transfer the tax liability to the older generation. Because you will owe taxes on any amount converted, you are essentially prepaying the taxes for your heirs.
The strategy isn't just generous; it may also be more tax efficient, especially if the conversions occur early in retirement. "Your earned income is down, and your tax bracket may be down," Worthington says. By comparison, the average age of a person receiving an inheritance is 51. Many people hit their prime earning years in their 50s, the worst possible time to be forced to withdraw from an inherited traditional IRA.
Along with tax-free withdrawals, a Roth IRA has an added bonus for heirs: They can leave the funds in the account to grow tax-free for 10 years. Because of that, their inheritance could be even more substantial.
Life Insurance Lets You Prepay the Tax Bill
Life insurance has become another tool for skirting the end of the stretch IRA. Distributions from your traditional IRA can be used to pay the premiums on a life insurance policy with your beneficiaries getting the death benefit once you pass away. For your heirs, this benefit is tax-free, though it counts as part of your estate. The federal estate tax exemption is $12.06 million for 2022, a threshold most Americans fall safely under, although 17 states plus Washington, D.C., have their own estate or inheritance taxes.
If you take more than your RMDs to buy life insurance, then your traditional IRA will have a lower balance for your heirs to withdraw. "Life insurance is a great way to prepay the tax bill," says Howard, who believes retirees should consider the policies for another reason. He once wound up in the hospital after an accident and was thankful that his life insurance would protect his family financially if he didn't survive.
Retirees are using RMDs to buy permanent life insurance for themselves or a spouse, says John Rothchild, a vice president and sales executive with expertise in trusts and estate planning at Arden Trust Co. in Wilmington, Del. Unlike term life insurance, permanent life insurance policies don't expire, and the death benefit is guaranteed as long as you pay the premiums.
You could go a step further and set up an irrevocable life insurance trust. This type of trust owns and controls the life insurance policy, distributing the death benefit once you pass away. It's a strategy used by highnet-worth individuals who could exceed the $12.06 million estate tax exemption, but as long as the policy is held in the trust, the death benefit would not count toward the estate. The death benefit can also be used to help heirs pay for estate taxes if the exemption threshold is reached, Rothchild says. Right now, few people feel the need to use a trust because the threshold is so high, he says, but at the beginning of 2026, when the current threshold expires, the exemption would revert to its pre-2018 level of $5 million adjusted for inflation.
Still, life insurance sometimes gets a bad rap, which Howard blames on sales tactics that use fear to push people to buy the product. Retirees also tend to think it's boring and sometimes bristle when an adviser recommends it. "I've never been yelled at except over life insurance products," he says. The loss of the stretch IRA hasn't motivated people to buy the policies, says Jamie Hopkins, managing partner of wealth solutions at Carson Group, an advisory firm in Omaha, Neb. For wealthy retirees, "it's likely life insurance was already in the conversation," he says. "I haven't seen a huge jump as it relates to the SECURE Act."
Some seniors might be better off taking RMDs they don't need and investing that money, rather than buying life insurance. Along with the potential for higher growth from the investment in a taxable account, the heirs also get a step-up in basis. As a result, when the assets are sold, the heirs are only taxed on any appreciation that occurred after the original owner's death. "To me the first thing to consider with life insurance is why do you want [it]," Young says. "For most people, you need it to replace lost income. With wealthier people, the discussion is often over the tax benefits."
A Split-Interest Trust Also Benefits Charity
A charitable remainder trust can also be used to mimic a stretch IRA, and there's been an uptick in interest in these. A CRT is an irrevocable "split-interest" trust that provides income to you and designated beneficiaries for up to 20 years or the rest of your beneficiaries' lifetimes. Any remaining assets are donated to charity, which must get at least 10% of the trust's initial value.
If you name the CRT as your IRA beneficiary, the IRA funds are distributed to the CRT when you pass away, and your estate will get a charitable estate tax deduction, not an income tax deduction, for the portion that's expected to go to charity, Rothchild says. The assets grow tax-free inside the charitable trust, which pays out a stated percentage to its beneficiaries each year. Between 5% and 50% of the assets should be distributed at least annually. For beneficiaries, the distributions are taxable income. (If you put nonretirement savings assets into a CRT during your lifetime, you would get an immediate income tax deduction.)
There are two types of CRTs. A charitable remainder unitrust lets you contribute more to the trust after it's created, with distributions determined annually based on the trust's value. A charitable remainder annuity trust, which pays out a set amount annually to beneficiaries, does not allow you to contribute more money once it is created. The present value of assets in the CRT that are expected to go to charity won't count toward estate and gift taxes, but the portion that goes to family or friends is still part of the estate and gift calculation, Hopkins says.
A CRT also protects the inheritance from a spendthrift heir. It works well "if I don't want my kids to have a million dollars on day one, and I want to give some to charity," Hopkins says. Your heirs could even end up with a larger inheritance because the trust distributes the money over their lifetime, versus a decade for a Roth IRA, giving the assets more time to grow.
Like other trusts, a CRT adds complexity and expenses to estate planning. A CRT can cost up to $8,000 to set up, plus annual fees of 1% to 1.5% for investments, and another 0.5% or so for filing the trust's tax return each year, according to advisory firm Beacon Pointe. Because of the cost, CRTs work best for retirees who have at least $1 million to leave to their heirs, Hopkins says.
What Does the Secure Act 2.0 Mean for You?
Last year, two members of Congress from opposite sides of the aisle did the unthinkable: They jointly proposed new legislation. Reps. Richard Neal, a Massachusetts Democrat who is chairman of the House Ways and Means Committee, and Kevin Brady, a Texas Republican and ranking member of the committee, introduced the Securing a Strong Retirement Act. Dubbed the SECURE Act 2.0, the proposal would make additional changes to retirement planning.
Some observers believe the legislation could easily pass with bipartisan support if the bill ever goes to the floor in either the House or the Senate, which could happen later this year. (A similar bill was also proposed in the Senate.) At the moment, Democrats have other priorities, leaving little time to take up yet another retirement package barely three years after the first one was passed. Ideally, the legislation should be passed as a standalone bill to help "shine a spotlight on the issue of retirement security," says Kevin Mechtley, vice president of legal and director of government affairs at Sammons Financial, which sells life insurance and retirement products. But lawmakers could add it to another piece of "must-pass" legislation, such as a fiscal year 2023 appropriations bill, adds Mechtley, who is cautiously optimistic that a second SECURE Act will pass in 2022. The original SECURE Act was passed in late 2019 after it was attached to the fiscal year 2020 spending bill.
If the bill does advance, here are three provisions to keep an eye on. All of them were included in the version of the bill that the House Ways and Means Committee passed last year.
Bigger catch-up contributions. Currently, people 50 and older can contribute an additional $6,500 in catch-up contributions to 401(k)s, 403(b)s and 457(b)s for 2022. The SECURE Act 2.0 would create a new age category for contributors -- those ages 62 to 64 -- and raise the catch-up amount for them to $10,000 each year starting in 2023.
That same age cohort would be able to contribute more to SIMPLE IRAs or SIMPLE 401(k)s annually, with catch-up amounts rising from the current $3,000 to $5,000 for those 62 to 64 years old. The law would also index catch-up contributions for IRAs to inflation starting next year. Since 2006, Congress has limited catch-up contributions to an extra $1,000 per year.
Raise the age for RMDs again. The original SECURE Act increased the age for required minimum distributions from 70½ to 72. This legislation would raise it again incrementally over a decade until the RMD age becomes 75 on Jan. 1, 2032. The penalty for failing to take an RMD would also be reduced from 50% of the shortfall to 25%. If the mistake is corrected quickly, the tax would be trimmed further to 10%.
More Roth options. Workers could get after-tax matching contributions from an employer to a Roth 401(k), 457(b) or 403(b) under the proposal. Currently, these matching contributions can only be pre-tax to these accounts. Also, right now employees cannot make Roth, or after-tax, contributions to SIMPLE and SEP IRAs, but the SECURE Act 2.0 would change that.