Under the SECURE Act, the Stretch IRA Has Snapped

In mid-December 2019–in a world far, far away from our current COVID state of mind—Congress passed a significant piece of legislation that has major implications for the retirement, tax and estate planning of many Americans.  Called “Setting Every Community Up for Retirement Enhancement” (a mouthful which  cleverly lends itself to the acronym “SECURE”), this Act and its major provisions have been the focus of many financial headlines, although some of the changes have garnered far more attention than others.

Loss of Stretch IRA

The part of the SECURE Act that you’ve probably heard about, especially if you have a retirement account and are turning 70-1/2 in or after 2020, is that the age for you to begin taking required minimum distributions (“RMDs”) has been extended from age 70-1/2 to age 72.  (If you turned 70-1/2 prior to 2020, you don’t qualify for this postponement.)  There were other significant provisions in the SECURE Act as well, but the one we’ll focus on here is the so-called “loss of the stretch IRA.” (These rules apply to inherited 401(k) accounts as well, but for simplicity we’ll use the term “IRA” throughout this blogpost to refer to affected accounts.)

Prior to the SECURE Act’s effective date of January 1, 2020, those who inherited IRA accounts could elect to “stretch” out the IRA distributions over their life expectancies.  Since these distributions are taxed to recipients at ordinary income tax rates, this stretch provision allowed the related tax liability to be spread out over a relatively long period of time.  Now, thanks to SECURE, this option is no more. (Mitt Romney is possibly to blame for this.  More on that later.)

10-Year Rule

Under the SECURE Act, a non-spouse beneficiary inheriting an IRA from the original owner who dies on or after January 1, 2020 is required to distribute the entire balance out of the account within 10 years following the death of the account holder.  Note that there is no annual RMD under the SECURE Act provisions, so the retirement assets can be distributed out in any amount during any of those 10 years.  Technically, there is only one RMD under the 10-year rule, and that is at the end of the 10^th year, to distribute out any remaining balance in the inherited IRA. 

It’s also important to note that while the 10-year payout rule applies to inherited Traditional IRAs, Roth IRAs, and 401(k) accounts, only the payments from Traditional IRAs and 401(k)s are taxable.  Roth IRAs must still be paid out over the 10 years but are not taxed.

Congress doesn’t pass anything without making exceptions, and there are some in this new rule, too:  If the IRA beneficiary is a surviving spouse, a minor child (although the 10-year rule still applies once the minor reaches majority age), a disabled or chronically ill person, or a beneficiary who is less than 10 years younger than the owner (such as a sibling), then the funds can still be distributed out over the beneficiary’s life expectancy, as the previous law provided. 

Also, remember that if you are a beneficiary of an IRA and the original owner of the account passed away prior to January 1, 2020, the former laws allowing the beneficial stretch IRA still apply, and you don’t need to think about this new 10-year rule.

Potential Tax Implications

Any IRA beneficiaries who don’t fall under the exclusions above, however, will be stuck with the new 10-year rule, and this includes adult children inheriting IRAs directly or through trusts.  Given that 10 years is not that long a period, and beneficiaries tend to inherit these assets in their peak earnings years, the new rule could create a considerable tax problem, as a result. 

Trusts as IRA beneficiaries can be particularly problematic if the IRA owner has set up the inheritance through a “conduit” or “pass-through” trust, which was designed to distribute only the pre-SECURE Act RMD, and no more, to the beneficiary each year.  This type of trust is often set up for the benefit of minors, the disabled, spendthrifts, and/or to protect assets from creditors, lawsuits, divorce, or second marriages.  But under the SECURE Act, given that there are no longer any RMDs for inherited IRAs, the entire payout of the account would occur at the end of the 10^th year, and the intended protections will expire along with the IRA account, nullifying much of the planning initially done by the account owner. 

Does it apply to you?

This all sounds very scary, but let’s pause here and clarify:  The loss of the stretch IRA isn’t a big problem for everyone.  If any of the following situations apply, you may not have an issue, and you can stop reading this wildly entertaining blogpost right now:

• You will likely spend through your entire IRA balance during your lifetime;
• The IRA balance your beneficiaries will inherit isn’t large enough to cause a significant tax problem for them;
• You’ve named a number of individual beneficiaries, and because they will all split the distributions, the 10-year rule will not create a significant tax problem for any one of them;
• You’ve named a charity as your IRA beneficiary; or
• Your beneficiary falls under one of the exclusions discussed above and therefore the stretch IRA rules still apply.

Proactive Planning is Critical

If, after reading all of this, you conclude that some proactive planning is needed for your IRA or 401(k), there are a number of strategies you could discuss with your advisor, estate attorney, and/or tax preparer that can help mitigate the 10-year rule.  Here are a few:

1. Re-evaluate some common beneficiary designations:  Surviving spouses are exempt from the 10-year rule, for example, but it also pays to think about what will happen at his/her death.  Will your children inherit an even bigger IRA, with even greater tax implications?  If your spouse doesn’t need your entire IRA to live on, you could split it up between him/her and the children at your death, so that your children can start a first, 10-year distribution period.  When your spouse dies, the children will start a second 10-year distribution period, thus potentially being able to stretch the total IRA distribution out over a period somewhat longer than 10 years.  You can also ensure that your beneficiaries are aware of the new 10-year rules and that they plan to take at least enough from the IRA in each of the 10 years after your death to fill up their lower tax brackets.  Another idea that falls under this category is to leave more of your after-tax assets to children, and leave more IRA assets to charitable beneficiaries.
2. Reconsider Trusts as an IRA beneficiary:  Trust planning can be a very complex area, so advice from a good estate attorney is essential.  You should request a review of the language in your Trust to identify any pitfalls related to the loss of the stretch IRA along with any corrective actions that could be taken, to confirm that your wishes will still be carried out after you pass.
3. If you’re in a lower tax bracket than your beneficiaries, consider taking more out of your IRA during your own lifetime:  This doesn’t mean you have to actually spend all the money you take out of the IRA—those funds can always be reinvested in an after-tax account.  But some well-thought out tax planning might result in you taking out more of your IRA assets to do a Roth Conversion, pay medical or long-term care expenses, do qualified charitable distributions to eligible charities, or to do some lifetime gifting that you will have a chance to enjoy real-time.  This can make even more sense when you consider that we are currently enjoying lower tax rates put into place by the 2017 Tax Cuts and Jobs Act, and that those lower rates are scheduled to sunset after 2025.

Other, more complex planning ideas appropriate for larger IRAs might include life insurance strategies and charitable trusts.  There are lots of ideas out there so again, a consultation with your planning team – advisor, estate attorney, and tax preparer – is critical.

You’ve suffered through this entire blogpost, patiently waiting to find out why this is all Mitt Romney’s fault, am I right?  So the story goes like this:  The idea of killing the stretch IRA may have gained momentum in 2012, when Romney, the former governor of Massachusetts and currently a Senator from Utah, ran for President against Barack Obama.  According to this Wall Street Journal article from January 2012, Romney was one of the wealthiest presidential candidates in decades, and like many Americans, he owned an IRA account.  However, his federal financial disclosure reports indicated that, unlike many Americans, his IRA held somewhere between $20.7 million and $101.6 million (apparently federal financial disclosure forms are allowed to provide extremely broad asset ranges, which seems bizarre in a financial planning context but may help to explain why our country has such problems balancing its own budget).  When Congress caught wind of Romney’s enormous IRA balance, legislative efforts to kill the stretch IRA started in earnest. 

Whether you want to blame Mitt or not, the reality is that the stretch IRA is mostly dead, and that may mean a re-evaluation of your estate plan is in order.