By Robert Prior
IRAs are about to undergo big changes that will impact the amount of savings your children will be able to accumulate when they inherit them. The House recently passed the SECURE Act (“Setting Every Community Up for Retirement Enhancement”). The Senate was expected to pass the bill shortly after the House, but the timing is now uncertain. The proposed law covers many issues regarding retirement accounts, but the most significant is a modification of the “stretch” IRA rules.
An IRA (Individual Retirement Account) is a tax-deferred savings plan which encourages Americans to save for retirement. In a traditional IRA, the money you contribute to an IRA is tax-deferred. You don’t pay income tax on contributions when you make them, but when you withdraw funds from the IRA in retirement, income tax is owed on the amount withdrawn. Under current law, you generally must begin taking withdrawals (and paying tax) at age 70 (the SECURE Act proposes to change that to age 72). Thereafter, you must withdraw an amount annually based on your remaining life expectancy as determined by IRS tables known as “Required Minimum Distributions” (RMDs).
Upon death, your IRA is left to the persons you legally designate. If that person is a spouse, they can treat the IRA as their own. When a non-spouse inherits your IRA (your children for example) different rules apply. The IRA is then known as an “Inherited IRA” or a “Beneficiary IRA.” Under current law, the beneficiary of an Inherited IRA generally has the ability to “stretch” the IRA payments by taking RMDs over the remainder of their life using their own life expectancy. This allows the principal of the IRA to continue to grow, tax-deferred, for the remainder of the beneficiary’s life.
A simple example demonstrates the power of the stretch. If an IRA owner leaves an IRA valued at $500,000 to a child when the child is 35, the Inherited IRA value would be in excess of $2.5 million by the time the child reaches age 70, even accounting for the child’s RMDs (assuming a 5% annual return).
How will the SECURE Act affect the stretch? Instead of allowing the IRA to continue to grow tax-free, the Inherited IRA beneficiary would be required to withdraw all sums from the IRA and pay all taxes within 10 years after the original owner’s death. The IRA value would not only be reduced substantially by income taxes paid at withdrawal, but the amounts withdrawn and re-invested would be subject to income tax on dividends and inter`est, and capital gain taxes on subsequent sales. Using the numbers from the prior example, and assuming a 25% marginal tax rate for the Inherited IRA beneficiary and a 5% return, the amount left when the child reaches age 70 would be reduced from $2.5 million to less than $1.3 million. This is a significant difference and does not even account for capital gains taxes that may be paid on stock trades outside of the Inherited IRA.
There are exceptions to the 10-year requirement. Distributions to minor children, disabled or chronically ill beneficiaries, or beneficiaries not more than 10 years younger than the deceased IRA owner would still be able to stretch the Inherited IRA (for minors until they reach the age of majority).
If the bill becomes law, all is not lost. There are other strategies which may reduce taxes on an Inherited IRA. These include switching to life insurance (gradually withdrawing money from your IRA at today’s lower tax rates and using it to purchase permanent life insurance, the proceeds of which are tax free); changing beneficiaries (leaving your IRA to a spouse instead of a younger beneficiary); converting to a Roth IRA (pulling money out of your traditional IRA at today’s tax rates and investing in a Roth whose earnings aren’t taxed); or using a charitable remainder trust (leaving your IRA to a charitable trust designed to pay regular income to your beneficiary for life, and upon their death the remaining money goes to charity).
Consult with your financial advisor and estate planning attorney to determine which strategies may be right for your situation.
