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George F. Bearup, J.D. Senior Legal Trust Advisor

2-Apr-18

Stretch IRAs Revisited

Take-Away: The tax planning concept of stretch IRAs survived the 2017 Tax Cut Act, and reports of the stretch IRA’s demise were premature. Stretch IRAs are still with us, but so are the often byzantine rules with regard to distributions from an inherited IRA. With the reprieve of the stretch IRA distribution rules let’s consider some simple examples.

Background: There was much discussion, and more than a little angst, in 2017 about the ‘death of the stretch.’ The elimination of the stretch IRA was discussed as a way to find new tax revenues to replace the expected loss of tax revenues that would result from the promised reduction in federal income tax rates. This proposal to eliminate the stretch IRA was accompanied with the proposal to reduce the amount that taxpayers could contribute, pre-tax, to their employer’s qualified retirement plans, e.g. a much lower ‘cap’ on pre-tax contributions to 401(k) plans. Neither of these proposals made its way into the final 2017 Tax Reduction Act, which came as a big relief to millions. But the fact that the stretch IRA was threatened with extinction was an important reminder that the stretch IRA is an incredibly powerful wealth accumulation tool.

Stretch IRA: A stretch IRA is an inherited IRA which permits the designated IRA individual beneficiary to stretch out both distributions from the inherited IRA, as well as the income tax bill that comes with each IRA distribution. This can result in substantial income tax savings over the years depending on the age of the designated IRA beneficiary.

Individual Beneficiary: In order to exploit a stretch IRA,  the beneficiary must be an individual, i.e. a living person with a life expectancy. An animal, charity, or the estate of the deceased IRA owner do not qualify as individual beneficiaries. A trust can qualify as an individual beneficiary [or more accurately it can be ignored since it, too, has no life expectancy] if the trust is drafted as a ‘see through’ trust, meeting 4 conditions. If it qualifies as a ‘see through’ trust,  the oldest individual trust beneficiary  will have their life expectancy used to calculate the required minimum distribution taken from the inherited IRA which is then paid to the trustee of the trust.

  • Example #1: June is a widow, age 76 years. June has one living child, Wally {Beaver died years earlier hang-gliding with Eddie Haskell.} June has been taking required minimum distributions (RMDs) since she turned 70 ½. June uses the Uniform Lifetime Table to calculate her RMDs; at age 76 the Table divisor for June is 22.0, which is used to calculate her RMDs. June dies at age 86 years, with Wally named as the sole beneficiary of June’s IRA. Wally is age 53 at June’s death. Wally must take June’s required minimum distribution for the year of June’s death, prior to December 31 for that year, if June did not take it earlier while she was still alive. But Wally will then switch and use the Single Life Expectancy Table to calculate his own required minimum distributions from June’s inherited IRA. At age 53 Wally’s life expectancy is 31.4 years using the Single Life Table. Wally takes his own RMD from June’s inherited IRA also by December 31 of the year of  June’s death; in short, the year of June’s death results in Wally taking two RMD’s- his late mother’s RMD that she did not take before her death, and his own RMD from June’s inherited IRA. The following year Wally must take another RMD from June’s inherited IRA, again using the Single Life Table,  the divisor for which is exactly one (1.0) year less than the prior year, i.e. 31.4 years (year of June’s death)– 1.0 year = 30.4 years is the life expectancy used to calculate Wally’s RMD from June’s inherited IRA in the next calendar year. [Note: Under the IRS’ Single Life Expectancy Table, RMDs do not exceed 5% of the IRA’s value until the beneficiary reaches age 67 years of age; accordingly, if the average investment return is 5%, the IRA could grow in value until the designated beneficiary reaches age 67, even while providing annual income to that designated beneficiary.]
  • Example #2: Same facts as above, except Wally dies shortly after his mother. Wally is survived by his only son, Ward Jr. Ward Jr. does not lose Wally’s stretch IRA just because Wally died. Ward Jr. will continue to use his late father’s RMD calculations, also following the Single Life Expectancy Table. So, if Wally dies in the year after June’s death, Wally’s and now Ward Jr.’s RMD will be 30.4 years. The year following Wally’s death, Ward Jr. will take an RMD using a 29.4 years life expectancy (using Wally’s initial life expectancy period, reduced by 1.0 year each of the following calendar years until the inherited IRA is exhausted by Ward Jr.)
  • Example #3:  Assume June dies without naming any beneficiary of her IRA. But Wally is her sole heir. Consequently Wally inherits June’s IRA, via the intestacy statutes of the state where June lived. Now, Wally’s stretch distribution period is much different. Wally will have to use June’s remaining payout period (she died at age 86) of 6.1 years, which is much shorter than the 30.4 year payout period available had Wally been named as June’s IRA beneficiary in a beneficiary designation.
  • Example #4: Same facts, but June died at age 65 years, not age 86 years, prior to her required minimum distribution age of 70 ½. June dies without naming Wally as the beneficiary of her IRA, but Wally is her sole heir at law, so Wally takes his late mother’s IRA through intestacy laws. Because June died before her RMD period began, Wally will have to completely withdraw his late mother’s IRA account balance over a period of no more than 5 years, in effect accelerating all of the income tax liability inherent in June’s pre-tax IRA.
  • Key Take-Away: Always name an individual beneficiary of an IRA, and confirm that there are contingent individual beneficiaries named for the IRA as well. Beneficiary designations should be checked annually to assure that living individuals are named.

Multiple Beneficiaries: It is far more likely that several individuals, and/or charities will be named as beneficiaries of an IRA. A stretch IRA is still possible, but some deadlines have to be met. Those key deadline dates are: (i) September 30 of the year following the year of the IRA owner’s death; and (ii) December 31 of the year following the year of the IRA owner’s death. The designated beneficiary of the inherited IRA will not be formally determined until September 30 of the year following the year of the IRA owner’s death. Distributions will be required to be taken by those determined designated IRA beneficiaries no later than December 31 of the year after the year of the IRA owner’s death; this December 31 deadline is the last date by which an inherited IRA can be split or divided among individual beneficiaries where the beneficiaries’ own life expectancies will govern their stretch distributions from their share of the inherited IRA.

  • Example #1: June, widower, names her two sons, Wally and Beaver, and her church as equal one-third beneficiaries of her IRA. Naming the church, a non-person, as an IRA beneficiary creates a problem since the church does not have a life expectancy. However, if the church is cashed out, receiving one-third of the IRA balance of June’s IRA before September 30 of the following year, the church will be ignored for the purpose of determining the sole designated beneficiaries of June’s IRA (only Wally and Beaver will be counted, the church will be ignored.) If the church is not cashed out by that date, then there will be no life expectancy available to use, and the stretch period that will be used for distributions from June’s IRA will be governed by June’s age at the date of her death (if she was over 70 ½ at that time, the payout period will be determined using her then life expectancy; and if June was younger than age 70 ½, then the payout of June’s IRA will be only 5 years.)
  • Example #2: Same facts. The church takes its one-third of June’s IRA prior to the next year September 30, so it is not treated as a designated beneficiary. Wally and Beaver, typical siblings, grieve for a short period of time after their mother’s death, but they shortly begin to fight over other aspects of their mother’s estate administration, and they refuse to work with one another. As such Wally and Beaver cannot agree on much of anything, and December 31 of the following year after June’s death rolls around and Wally and Beaver still  have not yet divided June’s IRA. When that December 31 RMD is taken, Wally’s life expectancy will be used for both his and Beaver’s distribution from June’s inherited IRA, since Wally is older than Beaver, and the oldest designated beneficiary’s age (determined as of the prior September 30) is used to calculate the RMD using the stretch IRA option. If in the following year Wally and Beaver finally get around to dividing the balance of June’s IRA they can do so,  but Beaver will still have to use Wally’s shorter life expectancy to take his required minimum distributions from his share of June’s inherited IRA until Beaver’s share of the IRA is depleted.
  • Example #3: Same facts. The church is cashed out by the next year September 30, so it is ignored for the determining the designated beneficiary of June’s IRA. Wally and Beaver promptly divide June’s inherited IRA into separate IRAs equal to 50% of the balance of the IRA after the church was cashed out.  Wally now has his own inherited IRA and Beaver has his own inherited IRA. Wally can take his own RMD using his own age for his stretch IRA distributions, while Beaver can do the same, using his own (longer) life expectancy to calculate his RMD from his share of the inherited June IRA.
  • Example #4: Start with the same facts. The change is that Wally dies after June, but prior to September 30 of the year following June’s death. The church is cashed out, but Beaver and Wally’s estate do not do anything with the balance of June’s IRA until after December 31 of the year following June’s death. We still must use Wally’s life expectancy, even though he is dead, to calculate the required minimum distribution from June’s inherited IRA on December 31. While the beneficiaries who drop out or formally disclaim their beneficial interests are not counted as beneficiaries on the September 30 ‘snapshot date’ that is used to identify the inherited IRAs designated beneficiaries, the life expectancy of a deceased beneficiary will continue to be used if that beneficiary dies within this ‘gap’ period- the period between June’s death and September 30 of the year following June’s death. I have no good explanation for this ‘rule’ it just is.
  • Example #5: June names her two sons, Wally and Beaver and the kid next door, Eddie Haskell, as equal beneficiaries of her IRA. [ June names Eddie since the kid seemed to spend his entire childhood living in the June’s kitchen, he never had any friends, and June felt sorry for him!] But with adulthood Eddie developed some good inter-personal skills, such that he was immensely successful in his business life. Consequently Eddie is a wealthy man who frankly has no real need to take any part of June’s IRA. As a result of Eddie’s good fortune, he decides to make a qualified disclaimer of his share of June’s inherited IRA, disclaiming his interest in June’s IRA within 9 months of her death, and prior to the September 30 of the following year beneficiary identification ‘snapshot date.’ With his disclaimer, Eddie is treated as having dropped out as a designated beneficiary of June’s IRA, and thus Eddie is not counted as a designated  beneficiary when September 30 arrives. [Note, though that if there are contingent beneficiaries named in June’s IRA, Eddie’s timely qualified disclaimer may result in some of the IRA assets passing to those other beneficiaries, e.g. June’s older sister who is named as a contingent beneficiary of June’s IRA,  might create new problems that will have to be addressed before the September 30 ‘snapshot date’ if part or all of Eddie’s share of June’s inherited IRA passes not to Wally and Beaver but to June’s sister.

Surviving Spouse Beneficiary: There even more distribution rules [an optimist would call them options]  if a surviving spouse is named as a beneficiary of an inherited IRA. A surviving spouse has more opportunities than other individual beneficiaries of inherited IRAs. The surviving spouse can either choose to remain the beneficiary of the deceased spouse’s IRA, or roll the balance of the IRA over into his/her own IRA.

  • Example #1: Ward dies naming his wife June, age 65, as his sole IRA beneficiary. June can choose to remain as the beneficiary of Ward’s IRA. She can take RMD’s from Ward’s inherited IRA without incurring a 10% early withdrawal penalty. You will recall that since RMDs are required to be taken from an inherited IRA, there is no early withdrawal penalty imposed on those RMDs.  Moreover, June is over the age 59 ½ when ward dies. If Ward was taking RMDs at the time of his death, then June will have to continue to take RMD’s from Ward’s inherited IRA. But June will take those distributions based upon her own life expectancy, and unlike the examples above where Wally was the sole beneficiary of his mother’s IRA, June’s distributions, as a surviving spouse, will be calculated using the Single Life Expectancy Table, re-determined each calendar year, as opposed to subtracting one full year for the following year’s RMD calculation.
  • Example #2: Same facts. This time, however, June decides to roll the balance of Ward’s IRA into her own rollover In this instance, June will not have to continue to take RMD’s from Ward’s IRA, it will be from  her own IRA; distributions can be postponed from June’s rollover IRA until June attains age 70 ½ years of age. That rollover decision permits June to delay taking RMDs for several years. When June does start to take those distributions from her own IRA she will use her own age and the Uniform Lifetime Table to calculate her RMD distributions. Note, however, that if June makes a rollover distribution from Ward’s IRA to June’s own rollover IRA account, and June takes distributions from her own IRA if she were under the age of 59 ½ years, then she would pay a 10% early withdrawal penalty, since she would be taking a distribution from her own IRA prior to that magic age.
  • Example #3: June is 55 years old when Ward, age 62, dies. June is named as the sole beneficiary of Ward’s IRA. June may need to access Ward’s IRA account to supplement her earnings, having lost access to Ward’s earnings on Ward’s death. If June rolls Ward’s IRA account balance to her own IRA, and she then takes a distribution, June will have to pay a 10% early withdrawal penalty along with the income tax on that distribution. If June decides to remain as the designated beneficiary of Ward’s inherited IRA, she can take RMD’s from the inherited IRA and not have to pay the 10% penalty. Note that when June reaches the age 59 ½ years she can then make a spousal rollover of the balance of Ward’s inherited IRA into her own Unlike non-spousal beneficiaries, a surviving spouse can make a rollover of the deceased spouses’ inherited IRA at any time. Thus, June may exploit the inherited IRA rules to avoid the 10% early distribution penalty to supplement her income after Ward’s death, but once June has passed age 59 ½ , when perhaps eligible to claim early social security retirement benefits, June can then make a rollover of the balance of Ward’s inherited IRA into her own rollover IRA and postpone any future distributions until June reaches age 70 ½ years.
  • Example #4: June survives Ward. June is named as the primary beneficiary of Ward’s IRA. Wally and Beaver are named as contingent beneficiaries of Ward’s inherited IRA. If June decides to take distributions from Ward’s inherited IRA (she makes no immediate rollover) Wally and Beaver will remain as contingent beneficiaries, and thus if June dies before depleting Ward’s inherited IRA, Wally and Beaver will split the balance of the IRA on June’s death, using June’s remaining life expectancy provided under the Tables. If June does not want Wally for a variety of reasons to inherit a part of Ward’s inherited IRA (e.g. he started to annoy her by acting like his friend, Eddie Haskell) then June needs to make a rollover of Ward’s inherited IRA to make it June’s own rollover Then June can name her own IRA beneficiaries, cutting back Wally’s share as a beneficiary, and permitting Beaver to receive more.

Big Time Mistakes: Beneficiaries often tend to treat an inherited IRA like any other assets that they inherit on the death of a family member. Worse, they may treat the inherited IRA like their own IRA. Making assumptions and mistakes with regard to an inherited IRA can lead to lots of tax and penalty nightmares. I will summarize some of these next week in another of my long and tedious summaries.

Titling the Inherited Stretch IRA: Because of the dangers of treating the inherited IRA somewhat causally by the designated beneficiary, Congress requires that the inherited IRA have a special name, so as to not confuse it with the designated beneficiary’s own traditional IRAs. Thus, when June dies, the inherited IRA received by Wally will be titled “June Cleaver IRA (deceased April 20, 2018) FBO Wally Cleaver, beneficiary.” If Wally is sloppy and simply directs that his late mother’s IRA be retitled as the “Wally Cleaver IRA” he will be treated as having received a distribution of the entire amount held in the inherited IRA, and it will be terminated and Wally will receive a 1099-R for the entire balance of June’s IRA as reportable taxable income in that year.

Conclusion: It is definitely a positive that Congress decided to permit designated beneficiaries to continue to use the stretch IRA distribution rules,  arguably long into the future in order to supplement their own retirement savings. The challenge is mastering the various distribution and timing rules and conditions, and not assume that all IRA beneficiaries will be governed by the same set of rules, or that non-spousal beneficiaries possess as much flexibility and choices as a spousal IRA beneficiary. Perhaps the biggest danger of all is that usually there are no ‘gate-keepers’ who stand between a designated beneficiary and his/her freedom to take a lump sum distribution from an inherited IRA. Often by the time the beneficiary consults with an advisor after the decedent IRA owner’s death, an IRA distribution has already been taken, and income tax liability incurred. Consequently it is important to educate the designated IRA beneficiaries, well before the IRA owner’s death, that they need to consult with advisors before taking the money and running.