The SECURE Act, passed in December 2019, brought some big changes to the rules governing retirement savings. Among the many reforms, the SECURE Act eliminates the “stretch” IRA for most beneficiaries, which could be disruptive for people who have built long-term financial plans around passing down, or inheriting, an IRA.
Here’s what you need to know to prepare for life after the stretch IRA.
The stretch IRA allowed a person who inherited an IRA to slowly withdraw funds from the account and create a lifetime source of income. However, with passage of the SECURE Act, those inherited accounts are now required to be entirely drawn down within 10 years unless you are eligible for an exception to the 10-year rule.
Because funds held in an IRA enjoy tax-deferred growth, the U.S. government now mandates accelerated withdrawals to — you guessed it — collect income tax revenue.
WHO’S EXEMPT FROM THE 10-YEAR RULE?
First, some good news. The 10-year rule only applies if the owner of the IRA died on or after Jan. 1, 2020. If you inherited an IRA on or before Dec. 31, 2019, this new rule does not apply to you, but it will apply to your beneficiaries if you intend to pass down your inherited IRA. Even with the new rule in place, certain beneficiaries remain exempt from the accelerated withdrawal rule:
- Surviving spouses
- Chronically ill or disabled beneficiaries
- A minor child of the employee (the 10-year payout rule does kick in when the minor reaches the age of majority where you live)
- A person no more than 10 years younger than the plan holder
PLANNING STRATEGIES IF YOU’RE A CURRENT IRA HOLDER
Consider an accumulation trust. You can designate assets in an IRA be distributed to an accumulation trust. While the account will still need to be drawn down within 10 years after your death, the trust can hold all those distributions while retaining the benefits of a trust. Although the IRA distributions might be taxed in a higher income bracket, the funds are protected against wasteful spending and creditors.
Include your spouse as a beneficiary. If your spouse has enough saved for retirement, you may have designated a child or grandchild as the beneficiary of your IRA. However, the 10-year rule will kick in at the time of your death. If you list your spouse as a beneficiary, your spouse can stretch distributions over the remainder of his or her lifetime because they are exempt from the 10-year rule. Your children or grandchildren would then receive the remaining assets from that IRA within 10 years of your spouse’s death. Essentially, you are potentially delaying the start of that 10-year rule by several years or more.
Consider a Roth conversion. To reduce the tax burden on beneficiaries, you could convert your traditional IRA to a Roth IRA. While you’ll pay income taxes on the amount converted, you can minimize the impact by spreading the conversion over several years. Then your grandchild, for example, can withdraw from the Roth IRA income tax-free over a 10-year period following your death.
Life insurance and non-qualified annuities. Proceeds from your life insurance or nonqualified annuity can help plug the holes in any lost income due to changes in the SECURE Act. What’s more, both of those assets can be used to provide your beneficiaries a lifetime stream of income in lieu of an inherited IRA.
PLANNING STRATEGIES IF YOU’LL INHERIT AN IRA
Be strategic about distributions. Rather than taking a lump sum at the end of 10 years, it might be more tax-efficient to take strategic distributions from an inherited IRA every year. You could take larger distributions during years when you’re in a lower tax bracket due to lower income, higher deductions, or other variables (vice versa when your tax burden is higher). You’ll want to work with a tax advisor each year to figure out how much can be optimally withdrawn.
A GOOD TIME FOR A CHAT
Keep in mind, these tips are guidelines not advice. Now that the SECURE Act is law, it’s a great time to reach out to your financial advisor or start a conversation with one. An advisor can help adapt your plan to the new law and keep you on pace to achieving your long-term goals.