Ranting About the “Death of the Stretch”

Take-Away: We will soon enter a new era when it comes to dealing with inherited IRAs and qualified plan accounts once the Senate passes its version of the SECURE Act. Congress’ stealth tax, by accelerating taxable distributions from IRAs and qualified plans, will force many who planned to leave their retirement accounts to their children and grandchildren, to reconsider what to give to them, and how those inheritances are received.

Background: The proposed SECURE Act eliminates what is known as the stretch IRA. Beneficiaries, other than surviving spouses, disabled individuals, and minors, will be forced to ‘empty’ an inherited IRA or qualified plan account over 10 years (or maybe even only 5 years if the concurrent Retirement Enhancement and Savings Act Bill prevails in Congress.) This 10-year payout rule  will result in a massive income-tax acceleration that bunches taxable income into a beneficiary’s higher marginal income tax bracket. It is estimated that IRA and retirement plan owners could lose up to one-third of their inheritance to income tax acceleration under the SECURE Act. Even the value of Roth IRAs will be diminished; while the beneficiary of a Roth IRA will not be forced to take taxable income over the 10 years following the Roth IRA owner’s death, those funds will lose their tax-free status after those 10 years, and Roth beneficiaries will then have to pay taxes on dividends, interest and realized capital gains after the ten-year payout period. Forcing a beneficiary to withdraw money from a traditional inherited retirement account over a 10-year period clearly does not provide a foundation for a healthy long-term financial plan as the sponsors of the SECURE Act claim.

Example: Archie dies leaving his $900,000 IRA to his daughter Gloria. Gloria is age 45 at the time of Archie’s death. Gloria earns $100,000 a year. Gloria’s expenses are $90,000 a year, adjusted annually by 3.5%. Gloria will retire at age 67 years with a Social Security retirement benefit of $40,000 a year. Assume Gloria’s rate of return on her invested inherited IRA is 7% a year. Using the existing stretch IRA rules, when Gloria attains age 86, she will have $2,236,538. In contrast, under the SECURE Act’s 10-year mandatory payout, Gloria will have $0.00 at age 87. While it may be called the SECURE Act, clearly it is not intended to make Gloria secure in her retirement years.

Emotional Reaction: Congress tries to sugar coat the SECURE Act’s bitter payout pill by extending an individual’s required beginning date by 18 months, permitting an individual to continue to contribute to an IRA after age 70, assuming that they are still working and have earned income, and it legitimizes ‘back-door’ Roth IRA conversions for those who earn too much to make a Roth IRA contribution. But for those individuals who ‘played by the rules’ for several decades contributing to their IRAs in the belief that their unused retirement benefits might assist their children or grandchildren in their own retirement years, the SECURE Act is nothing more than ‘changing the rules’ late in the game. The same can be said for unused Roth IRA balances, which now will cause Roth beneficiaries to incur income taxes after 10 years, when the sponsor of the original Roth IRA distribution rules claimed that the beneficiaries of a Roth IRA would never pay income taxes on the income generated by their inherited Roth IRA.

Planning Reactions: A handful of planning strategies might be considered if an individual has accumulated substantial amounts in IRA and 401(k) accounts over the years in anticipation that their designated beneficiaries would be able to incrementally withdraw those taxable funds over their lifetimes. These techniques were summarized in the prior missive. A couple are repeated in the following paragraphs.

• Life Insurance: Due to the dramatic acceleration of taxable income caused by the SECURE Act, thus exposing that income to marginally higher income tax brackets, a family might consider purchasing some life insurance in the form of a second-to-die policy, on the IRA owner’s life. The tax-free death benefit could be used to help defray the income tax liabilities attributable to the inherited IRA. Maybe a small portion of the IRA owner’s required minimum distribution (RMD) could be used to help pay the premium on such a life insurance policy. It should come as no surprise that the insurance industry is a strong supporter of the SECURE Act, probably because it plans to sell a lot more annuities to beneficiaries who initially thought that they could rely on their inherited IRA for income in their own retirement years.
• Roth Conversions: If the IRA owner converts his/her traditional IRA over a several year period to a Roth IRA, then the inherited Roth IRA can defer income taxes for at least 10 years. Rather than having all of the traditional IRA balance subject to income taxation over 10 years, a portion of the traditional IRA converted to the Roth IRA avoids, at least for 10 years, immediate income taxation, which will lessen, but not eliminate, the bunching of taxable income into a relatively short period of time. Roth conversions may make sense today with the relatively low(er) income tax rates until 2026.
• Example: Edith earns $100,000 a year. Edith is currently in the 24% marginal federal income tax bracket. Edith could pick up an additional $220,00 in taxable income (via a Roth conversion of her traditional IRA) so that her reported taxable income for the year would be $320,000, yet Edith would still be at the marginal 24% federal income tax bracket. Note, however, that with higher taxable income Edith may face increased Medicare Part B and D premiums. More to the point, in order to increase her Roth IRA, Edith with have to pay more income taxes this year- more revenue for Congress to waste.
• Charitable Remainder Trusts: We have covered this a couple of times in the past. If the IRA is made payable to a charitable remainder trust (CRT) then the trust does not recognize any taxable income on the distribution from the IRA, as the CRT is a ‘charity’ that normally does not pay income taxes. The distributions from the CRT to the named CRT beneficiary will be taxable income, but that income is distributed to the beneficiary from the CRT over the beneficiary’s lifetime, not just 10 years. Accordingly, the CRT acts as a surrogate stretch IRA. This fund-a-CRT strategy may be even more attractive if Congress’ final legislation results in a 5-year mandatory payout of all retirement accounts. At least 10% of the initial value of the IRA balance paid to the CRT must be earmarked for the charity’s remainder interest to determine the CRT beneficiary’s distribution, so if the IRA owner is not charitably inclined, using a CRT as a surrogate stretch IRA will probably be a non-starter.
• Conduit Trusts: Existing conduit see-through trusts no longer make much sense if there exists a 10-year mandatory payout from an IRA that is made payable to an  irrevocable trust. The trust can still provide some creditor protection to the beneficiaries with regard to the IRA assets, but the traditional IRA must still be fully taxed within 10 years of the IRA owner’s death. Those individuals who relied on the see-through trust technique over the past couple of decades will now have to re-visit the utility of their trusts and no doubt incur legal fees to change them.
• Spend It!: Many retirees do not fully spend their income in their retirement years. They should consider spending more of their retirement assets while alive, in light of the painful income tax erosion of their retirement assets when that wealth is ultimately inherited. The IRA owners should consider playing the ‘run-up’ of the income tax bracket strategy [described above under the ‘Roth conversion example ’] but instead of converting the sums of traditional IRAs to Roth IRAs (which still have a 10-year payout obligation) they simply pull more money out from their retirement account and spend it on themselves, like taking the entire family on a well-deserved vacation to Maui in February.

Conclusion: The SECURE Act’s 10-year payout acceleration of income taxes betrays conscientious savers who set-aside funds from their normal spending on the promise that they would be able to pass along that saved money to their children and grandchildren in an income tax-efficient manner. I can’t wait to hear all the members of Congress running for re-election next year tout how they only voted to reduce income taxes, yet never acknowledge that they accelerated billions in taxable income and intentionally exposed that income to marginally higher income tax rates. End of rant!