Strategies After the Elimination of Stretch IRAs

The SECURE Act will take effect on January 1, 2020. One of the Act’s most significant changes is the elimination of stretch IRAs. Before the passage of the SECURE Act, a non-spouse could stretch an inherited IRA over their lifetime. In 2020, other than the listed exceptions, a non-spouse beneficiary will have to deplete an inherited account within ten years. The SECURE Act provides exceptions for the following beneficiaries: a surviving spouse, retiree’s child(ren) if under the age of majority, disabled or chronically ill, and an individual not more then ten years younger than the retiree.

We can better understand the impact of the SECURE Act’s elimination through the following examples:

• Suppose there was no SECURE Act and Husband died in December of 2019. The surviving spouse is named as the beneficiary and their children are named as contingent beneficiaries. The surviving spouse would take the required minimum withdrawals (RMDs) over her lifetime, and once she passed, the children would inherit the IRA and take RMDs over their lifetimes.

• Now assume Husband died in December of 2019 before the SECURE Act takes effect and the surviving spouse does not need the IRA funds. The likely best option would be for the surviving spouse to disclaim the funds so that the IRA can go to the children. This is the best option because the children can still stretch the withdrawals over their lifetimes since they inherited the account before 2020. However, if the surviving spouse were not to disclaim and die after the SECURE Act takes effect, the children would have to deplete the account within ten years.

• Finally, assume Husband dies in January of 2020 after the SECURE Act takes effect and the surviving spouse does not need the IRA funds. One option would be for the surviving spouse to take some of the IRA funds and leave the rest to the children. By taking some of the funds the surviving spouse creates two ten-year withdrawal periods for the children, the first when the husband died and the send when the surviving spouse dies.

• Suppose the retiree named a conduit trust as the IRA beneficiary. In a conduit trust, all RMDs must be distributed annually as they are received. Prior to the SECURE Act, conduit trusts worked well because they provided slow distributions that protected possibly irresponsible beneficiaries from receiving large lump sums. Post SECURE Act, the conduit trust may not be as beneficial since it would result in either substantial withdrawals over ten years or a tremendous withdrawal at the end of the ten-year limit. Either way, post SECURE Act conduit trusts will no longer serve as a shield for potentially irresponsible beneficiaries and may cause beneficiaries significant tax disadvantages. Retirees utilizing a conduit trust may want to talk to a professional about removing conduit language in favor of accumulation because an accumulation trust would allow for discretionary distribution.

With the SECURE Act taking effect January 1, 2020, financial advisers and attorneys are looking for strategies to help retirees attain results similar to the once promised stretch IRA. Below are three possible solutions.

1. Roth Conversions

A Roth conversion involves transferring all or part of an existing traditional IRA to a Roth IRA. Under traditional IRAs, contributions are tax-free, but not withdrawals. Since the SECURE Act requires accelerated withdrawals within ten years, the resulting larger withdrawals can cause detrimental tax burdens to a beneficiary. This is especially true if the required withdrawals are during a beneficiary’s peak work and tax years. Under Roth IRAs, withdrawals are tax-free, but not contributions. In addition, Roth IRAs have no RMDs during a retiree’s life.

A Roth conversion enables a retiree to pay taxes while they are alive so that their beneficiaries can take tax-free withdrawals. There are some limitations to Roth conversions. For instance, inherited IRAs and education IRAs cannot be converted into a Roth IRA. In addition, a retiree’s income must be less than $137,000 for singles and $203,000 for married couples. Finally, Roth IRAs have annual contribution limits of $6,000 and $7,000 if the IRA owner is 50 or older. A retiree wanting to pass down wealth may want to consider utilizing Roth conversions, in essence taking a tax hit now so their children will not have to.

2. Charitable Remainder Trust

We've written about this strategy here. We think this has the most upside.

3. Life Insurance

Finally, a retiree can use a life insurance policy. One option is for a retiree to use their RMDs to fund the premium payments of a life insurance policy. The policy would then pay out to the retiree’s beneficiaries to offset the loss due to tax. Another option is for a retiree to create trust, which would subsequently take a life insurance policy on the retiree. At the retiree’s death, the policy would pay out to the trust and the trust would distribute the funds to the beneficiaries according to the trust agreement.

Conclusion

With the elimination of stretch IRAs many retirees will need to review their retirement plans. After the SECURE Act takes effect in 2020, current retirement plans may no longer be the most tax-efficient way to pass down wealth. Review and discuss your retirement plans with a qualified professional to see which strategy is best for you.