IRAs: “Death of the Stretch” (continued)

Take-Away: There still might be a couple of planning opportunities available to clients if Congress decides to eliminate the stretch IRA rule. It might be a good idea to start some dialogue with clients at an early date to prepare them, and their plans, for the death of the stretch.

Background: A few days ago I wrote about the probable death of the stretch IRA as a probably outcome of President Trump’s initiative to reduce income tax rates across the board. The end of the stretch IRA would generate more revenues for the government to offset, in part, the reduction in revenues that will result from a reduction in income tax rates.

The Senate Finance Committee voted last October, 21 to 0, to eliminate the stretch IRA, and replace it, [with a couple of exceptions e.g. a surviving spouse inheritor; a minor child inheritor; a disabled child inheritor] with a mandatory payout period for the inherited IRA of five (5) years from the IRA owner’s death. If a minor is named as the IRA beneficiary, then he/she would be required to empty the IRA through withdrawals within 5 years after attaining age 18 years, so it is  not more of much of a stretch if a minor is named as the IRA beneficiary. Since both Republicans and Democrats unanimously voted to eliminate the stretch IRA last October, there is a very good chance that the stretch IRA distribution strategy is on its last legs.

One planning complication that arises from the Senate Finance Committee’s proposed elimination of the stretch IRA would be to permit an IRA owner’s inheritors to continue to stretch required minimum distributions (RMDs) over the inheritor’s life expectancy for $450,000 of the decedent’s IRA. But that $450,000 ‘carve out’ exempted amount  is for all IRAs owned by the deceased IRA owner, not for each IRA  that is owned (or 401k, or profit sharing, or 403(b), or 457 retirement accounts for that matter) all owned by the same individual. Rather, the proposed $450,000 exemption amount that is permitted to be stretched over the beneficiary’s life expectancy applies in the aggregate to all of the decedent’s retirement accounts (not just to IRAs.)

Added to this complication is that the proposed $450,000 exemption amount that can be stretched is allocated pro rata among all of the retirement accounts’ designated beneficiaries, which will make it impossible to cherry pick which beneficiary gets to exploit the proposed  $450,000 stretch exemption amount over his or her life expectancy. For example, if I have $600,000 in my IRA and I name three non-spousal beneficiaries for my IRA, each of them can stretch $150,000 of their $200,000 share of their inherited IRA; the balance of their share of the inherited IRA, or $50,000, must be withdrawn within 5 years of my death. I cannot pick my youngest designated beneficiary and allocate to him/her my full proposed $450,000 stretch exemption amount.

Thus, retirement distribution planning will get very complicated real quick if I have multiple IRAs or retirement accounts, and multiple designated beneficiaries spread over those retirement accounts, when only $450,000 of assets can be stretched among all of those beneficiaries from all of my retirement accounts.

Future Planning: While ACTEC and other professional groups are currently proposing to Congress a different set of rules if the death of the stretch is soon to be upon us [ACTEC is proposing a flat RMD period of 20 years for all beneficiaries with no exceptions [e.g. spouse, minor, disabled beneficiary, and dropping the proposed $450,000 stretch exemption amount as simply too unwieldy to implement]. If the professional groups’ proposals are unsuccessful to change the Senate Finance Committee proposed legislation, there are a couple of planning strategies that should be raised with clients in anticipation that the stretch IRA planning opportunity will soon disappear.

• Disclaimers- the Proposed $450,000 Exemption: Under the Senate Finance Committee’s proposal each taxpayer has a $450,000 stretch exemption amount. But like the old federal estate tax exemption before portability came along, under the Committee’s proposal, it is a use it or lose it type of exemption. Example: Assume that my wife and I each own an IRA with  $500,000 of assets. Conventional wisdom is that I name my wife as the primary beneficiary of my IRA. I die first. My wife rolls over my IRA to her IRA. My wife then dies with $1,000,000 of IRA assets [her original $500,000 and the $500,000 that she rolled over upon my death.] My wife names our two children as the beneficiaries of her $1.0 million IRA. Each child inherits $500,000 of their mother’s IRA assets. But my wife has allocated to her IRA only $450,000 of stretch exemption. Thus, while my children each inherit $500,000 of IRA assets, they can each only stretch $225,000 of that inherited IRA. That means that each child will have to withdraw the balance of their inherited IRA,  $275,000 each,  within 5 years of their mother’s death. My wife was not able to use my $450,000 stretch exemption amount; it was not used because I named her as my IRA beneficiary and she rolled the amount over to her own IRA.. In short,  there is no portability of my $450,000 stretch exemption amount to my surviving spouse. If my wife felt financially secure upon my death, and if I had named my children as the contingent beneficiaries of my IRA, my wife could have disclaimed $450,000 (or any lesser amount) of my IRA within 9 months of my death. That means that my children could each have inherited $225,000 of my IRA on my death and they would be able to stretch distributions form that inherited IRA over their life expectancies. Upon my wife’s subsequent death, our children could inherit another $225,000 each of her IRA and subject that amount to the conventional stretch distribution rules over their life expectancies. In summary, if my wife disclaims $450,000 of my IRA upon my death, ultimately our children will be able to stretch, in the aggregate between them, $900,000 of our combined $1.0 million in IRA assets over their life expectancies. Only $100,000 [$50,000 per child] would have to be withdrawn  by our children within 5 years of their mother’s death.  To implement this disclaimer planning, two things need to happen: (i) my children need to be named as the contingent beneficiaries of my IRA so that the disclaimed amount will pass directly to them if my wife decides to make a timely qualified disclaimer within 9 months of my death, to use of part or all of my anticipated stretch exemption amount; and (ii) my wife needs to be counseled shortly after my death to not make a knee-jerk rollover of my IRA to her own IRA- once she rolls over my IRA into her IRA, she can no longer disclaim the rollover amount, as she has taken dominion and control over the inherited asset. Consequently what needs to be shared with married clients at this time is: (i) the perceived benefits of a qualified disclaimer; and (ii) the need go slow  in the decision to make a spousal IRA rollover, to permit an assessment of the possible benefits of a disclaimer of $450,000 of the deceased spouse’s IRA.
• Charitable Remainder Trust as IRA Beneficiary:  The primary benefit of a stretch IRA is to defer the recognition of taxable income as long as possible, and to permit the assets not yet subject to distribution to growth in an income tax deferred environment. If the deferral of taxable income recognition is fundamental to the benefits of a stretch IRA, a client might consider naming a charitable remainder unitrust (CRT) as the beneficiary of their IRA. Their child could be named as the beneficiary of the CRT. Since the CRT is a tax exempt entity, it could receive all of the IRA assets paid to it on the IRA owner’s death without immediate income taxation. The CRT would then make annual distributions to the child over the child’s lifetime, much like  distributions from the inherited IRA would be taken by the child. In short, the CRT is used for lifetime deferral of income recognition much like what was available under the stretch IRA. However, there are some possible drawbacks to this optional deferral technique. First, the client should have some charitable intent, since at least 10% of the CRT assets (actuarially calculated when the CRT distribution amount is determined) that will have to be paid to a charity upon the child-CRT beneficiary’s death, so if the client is not charitably inclined, probably the CRT is not a viable option. Second, the CRT must annually file an income tax return and prepare a K-1 for the child CRT- beneficiary, so there are more costs associated with using a CRT as an income recognition deferral device. An often used rule-of-thumb is that a CRT ought not be used unless there are at least $500,000 of assets that pass to the CRT to justify the additional administrative expenses associated with the CRT over the beneficiary’s life expectancy. Consequently,  a smaller amount held in an IRA may not warrant the use of a CRT. For example, if my IRA held $800,000 and I named my children as the beneficiaries of $450,000 of that IRA, so that they could stretch distributions under the Senate Committee’s proposal, that would leave only $350,000 to be available for possible distribution to a CRT;  if I plan to treat my 2 children equally, that would mean that only $175,000 would be distributed to a CRT established for each child- probably not enough to warrant serious consideration of the CRT. But if I owned a jumbo IRA, let’s say with $2,000,000, I could leave $450,000 of my IRA to my children outright,  to permit them to each stretch $225,000, and the balance of my IRA, or $1,550,000 I could then leave to two CRTs, one for each of my children. Under this example, each CRT would then initially hold $775,000, an amount above the rule-of-thumb mentioned above. One other possible benefit from the exploitation of a CRT to receive some, or all, of my IRA is that the CRT can be structured as a spendthrift trust to provide creditor protection for the beneficiary. You will recall that the Supreme Court held a couple of years ago that an inherited IRA is not protected from creditors or in bankruptcy; thus, directing the IRA to a trust to provide for the beneficiary’s lifetime benefit would provide greater protection for the beneficiary fro. creditor claims. It might also be possible to construct the CRT to comply with Michigan’s new Qualified Dispositions in Trust, aka asset protection trust, which may provide even greater protection to the IRA assets.

Conclusion: While the death of the stretch has not yet arrived, we should begin to have conversations with our clients  as to what the repeal of the stretch will mean for their estate plans and to take a second look at how they will dispose of their retirement account balances.