So Much For the Stretch…
For most of this year, our discussions have focused primarily on Covid, the markets and, to a lesser extent, politics (or at least their impact on the markets). We know we can continue focusing on those subjects, but this month we would like to pivot and revisit a topic we last discussed in our January letter – the SECURE Act and its implications for your IRA.
The SECURE Act (the “Act”) went into effect in January of this year and was one of the rare acts of bipartisanship we have seen over the last few years.
The Act had some positive changes, such as the ability to begin taking required minimum withdrawals (RMDs) from retirement accounts at age 72 instead of age 70.5 (only 2-year-old children and the IRS count ½ years). Interestingly, the SECURE Act part 2 is working its way through Congress as we speak. If passed, it looks like the start date for RMDs may be pushed back from 72 to 75. For many, that can provide even more planning opportunities and flexibility.
However, the Act also had a negative change – the elimination of the “stretch IRA”.
Some of you may be scratching your head – “stretch IRA”? Let’s just call it the Stretch.
The Stretch allowed non-spouse beneficiaries of an IRA (like your kids) to stretch the withdrawals from that IRA over their lifetimes. So, let’s say that you have an IRA with $1 million and you leave it to a child who has an expected remaining life span of 50 years. That child would have been able to limit required withdrawals from the IRA to about $20,000 in the first year (future withdrawals would be a function of the value of the IRA and the remaining life expectancy).
The beauty of the Stretch was that it allowed the beneficiary to decide how to use the IRA based on their specific circumstances. If they needed the funds or were in a low tax bracket, they could take distributions quickly. If they didn’t need the funds and/or were in a relatively high tax bracket – or would move to a high tax bracket with the additional income from the IRA – they could use the rules to take smaller distributions over time.
Well, the IRS wasn’t really too fond of the Stretch. You see, they figured that you already had a pretty good deal with an IRA. They let you defer taxes when you contributed and also let the amount grow tax free. In return, they mandated required minimum withdrawals from the IRA once you reached a certain age with the expectation that they would finally be paid the taxes over the remainder of your life. Due to the Stretch, there was the potential that they would not fully get the tax revenue until the end of your beneficiary’s life.
The Stretch was a loophole that a lot of people incorporated into their estate plans. The Act removed that loophole and, as a result, may require some rethinking of estate plans. The Act limited the maximum withdrawal period for non-spouse or disabled beneficiaries to just 10 years. Going back to our prior example, over the first 10 years, assuming a ratable distribution (which is probably not likely), your beneficiary would have realized about $200,000 in additional income. Under the new rules, over that same 10-year period, your beneficiary would be forced to recognize the full $1 million in income. Clearly, that can result in a potential tax nightmare. It is even worse for those with larger IRAs.
So, what do you do if you had planned on using a Stretch?
Explore a Roth Conversion Now: While not ideal, doing a Roth conversion now will allow you to time the realization of the taxes while you are alive and while tax rates may be lower for you than they will be for your heirs. While your heirs will still need to take the funds within 10 years, there will be no taxes due at that time. Again, not ideal, but it gives you a measure of control.
Give to Charities: If charities are part of your estate plan, you can potentially use the tax code to your benefit. The current tax code makes it difficult to get a meaningful deduction from charitable giving unless you give from your IRA. You can give up to $100,000 from your IRA to a qualified charity and pay no taxes on the distribution. In other words, the charity gets the money, and you don’t record any income. Better yet, this can count towards your RMD if you do not need the funds for your personal use. So, rather than leaving money to your kids in the IRA, use the IRA to make tax free charitable contributions now and take the charities out of your estate plan (or reduce what’s going to them). That will leave less money in IRAs, reducing the tax implications for your heirs. There are other estate maneuvers that might further reduce their burden, but that’s for another discussion. Another positive, giving while you are alive lets you see firsthand all the good you are doing.
Take Advantage of Advanced Techniques: For those with very large IRAs ($2 million or more), there are strategies that are particularly effective in 2020 due to the CARES Act, which was passed in connection with Covid. These strategies have the potential to allow you to terminate your IRA and remove the assets from your estate while realizing little or no taxable income. As such, the taxation is reduced significantly. The upshot is that there are legal and other fees involved, but for larger IRAs, the result is something on the order of 7-10% taxes/fees (the larger the IRA, the smaller the percentage) vs. 37%+ in taxes (that’s without consideration of state taxes). Since the assets are also removed from your estate, they are no longer at risk from law suits (if that is a fear) and there are no estate taxes on this portion of your assets for your heirs to worry about (another problem with IRAs), which may become a factor if tax rules are changed.
Consider Insurance: While not glamorous, life insurance is a tool that has been used for decades by parents/grandparents who wish to ensure that their children/grandchildren are protected from the impacts of estate and other taxation. Since life insurance proceeds are received tax-free, a policy that is large enough to pay any projected taxes will ensure that your heirs can get the full (or a fuller) benefit of any inheritance. Many opt to use RMDs that otherwise would not be needed to cover the cost of the premiums.
Use Advanced Pension Designs: Similar to the advanced techniques discussed above, this is relegated to the realm of larger IRAs, but there may be opportunities to consider the use of LLCs, pensions and life insurance to help preserve the value of your IRA and ensure your heirs remain “whole”.
Dealing with estate plans, beneficiaries and IRAs in general can be a bit overwhelming. We are here to discuss the various approaches and help you determine which is best for you.
Have a great month. With any luck, by the time our next letter is posted, we will know who has won the election and we can begin the process of coming together as a country.