Prepare for the Death of the Stretch IRA
No laws affecting retirement plans are final yet, but there are certain changes on the horizon that may require tweaks to your estate plans.
The Setting Every Community Up for Retirement Enhancement (“SECURE”) Act recently passed the House with enormous bipartisan support (417-3!). If adopted by the Senate, it will significantly alter the way retirement plans are distributed after the retirement plan owner’s death.
Under the current law, non-spouse beneficiaries can stretch required minimum distributions over the course of their life expectancy. For example, an 18-year old beneficiary with a 65-year life expectancy would stretch out the distributions over 65 years. This allows a beneficiary to minimize the amount required to be withdrawn in any year, which contributes to more income tax-deferred growth.
The SECURE Act will require non-spouse beneficiaries to withdraw all retirement assets within ten years of the owner’s death. There are certain exceptions for beneficiaries who are disabled or chronically ill, or beneficiaries who are less than ten years younger than the account owner. Additionally, minors can delay withdrawal until ten years after reaching the age of majority. But apart for these exceptions, opportunities for stretching the IRA over an extended period of time will not longer be available.
Many estate plans that created trusts to hold retirement assets for asset protection purposes included conduit trust provisions. Conduit trusts receive required minimum distributions from an inherited IRA and immediately pay the distributions to the trust’s beneficiary. These provisions are a safe harbor see-through trust, which allows the primary beneficiary of the trust, rather than the trust itself, to be the designated beneficiary and measuring life for purposes of determining the required minimum distribution. In contrast, accumulation trusts allow the trustee to retain required minimum distributions in trust, but required minimum distributions are tied to the life expectancy of the oldest potential beneficiary of the trust.
If the SECURE Act becomes law, planning strategies will change. Estate plans that include trusts with conduit language will need to be modified because they will no longer be required minimum distributions; rather, all funds would need to be withdrawn within 10 years, leaving no assets in the trust. Because beneficiaries pay tax on RMDs at their personal tax rates, a large inherited IRA may result in a significant income tax burden.
Trusts drafted as accumulation trusts are not required to make distributions to beneficiaries, but distributions from traditional IRAs which are retained in trust would be exposed to compressed income tax rates that apply to trusts. Currently, trusts reach the maximum 37% tax bracket with undistributed taxable income of $12,950.
IRA Expert, Ed Slott, has written some articles suggesting different planning strategies in the event the SECURE Act becomes law. One involves converting a traditional IRAs to Roth IRAs. Although this will result in a big tax bill in the short term, beneficiaries would inherit the Roth IRAs completely tax free regardless of how much the assets have appreciated. Additionally, there would be no tax on distributions from the inherited Roth IRA to an accumulation trust.
Another strategy that Slott recommends is withdrawing some of the IRA to invest in life insurance, and directing death benefits into a trust for your beneficiaries. This will avoid tax rules associated with withdrawals of retirement plan assets, and allow for asset protection for the trust assets.
Those with charitable inclinations can make use of charitable remainder trusts (CRTs). The CRT could be named as the beneficiary of an IRA. After the IRA’s owner passes away, the trust can make monthly, quarterly, semi-annual or annual distributions for a beneficiary’s lifetime, and at the end of the trust, the remaining assets would be distributed to a named charity.
There are no easy solutions, and each solution comes with potential drawbacks. So it is important that you start considering the options with your financial advisor and be prepared for the possibility of modifying your estate planning documents once we have clarity on what the new legislation.