The SECURE Act of December 2019 was intended to give Americans a better shot at retirement security. But retirees whose estate plans depended on the so-called stretch IRA may see that as, well, a bit of a stretch. That’s because the law sharply curtails this simple, tax-efficient way of leaving money to future generations.
Take, for example, a 71-year-old grandma leaving her IRA to her 22-year-old grandson. Before 2020, he could stretch distributions from the account – and the resulting tax liability – over his 55-year life expectancy. In the wake of the SECURE Act, he must withdraw all the money within ten years of receipt – 45 years fewer! It doesn’t take a CPA to realize this condensed timeline will result in much larger annual distributions and tax bills, plus significantly reduced tax-deferred growth.
That’s only one of many scenarios where retirees could see their legacies take a haircut due to the new legislation. Let’s take a closer look to see who is affected and how best to respond.
Stretch IRA (Mostly) Eliminated
Many beneficiaries of tax-advantaged retirement accounts must drain them within ten years or pay a 50% penalty. But there are exceptions.
For example, for accounts whose owner died before January 1, 2020, beneficiaries are grandfathered into the old rules. Going forward, only three types of beneficiaries remain eligible for the stretch IRA.
- Chronically ill or disabled individuals
- Heirs not more than ten years younger than the account owner
It’s nice that spouses will still receive the benefits of stretch provisions, but this does create a potentially important conversation for nonmarried partners since a nonmarried partner listed as an IRA beneficiary would not be eligible for the stretch provision. This may not be an important consideration for many, as marriage is much bigger and greater than a financial arrangement. But for some non-married partners, especially when the age difference is greater than ten years, securing a stretch provision may be worth considering.
Minor children of the original account owner get a bit of a reprieve. They are not required to begin RMDs until they reach the age of majority. However, at that point, they are subject to the ten-year drawdown like everyone else.
The upshot? Families whose estate plans made use of the stretch IRA may want to consider new wealth transfer strategies. Some strategies can be implemented by beneficiaries after inheriting. Other strategies must be implemented by the account owner before assets pass to heirs. 1
Strategies for Beneficiaries
A few interesting provisions of the SECURE Act open up new planning options for beneficiaries. First, unlike in the past, the new law does not dictate a minimum amount that must be withdrawn per year. As long as the account is drained by Year ten, there is no penalty.
Second, the law specifies that RMDs begin the year after the account owner dies. However, if the death occurs early enough in the year, beneficiaries may have time to make a withdrawal that year as well. That creates an extra year over which to spread out the tax burden.
The question for each beneficiary then becomes how to spread distributions over the 10- or 11-year window. The answer depends on several factors:
- Roth or traditional IRA
- Size of account
- Variability of income
- Income tax bracket
With Roth IRAs, distributions aren’t taxable. So the opportunity lies in capturing maximum tax-free growth. That’s why it’s often best to wait until the final year to withdraw the entire amount.
Traditional retirement accounts are trickier. If the account balance and tax rate are low enough, it might not matter much. Larger accounts present a bigger, albeit nice, problem to have.
Let’s say our hypothetical grandson graduated into a post-COVID-19 job market and has very little income. He could probably withdraw half of a $50,000 IRA inherited from grandma without exceeding the 12% Federal tax rate. If grandma’s bequest totaled $500,000, taking half would not be such a good idea as it could jump him into the 35% bracket. In that case, a little planning could save a lot of money.
The same is true for heirs whose income is expected to fluctuate after inheriting. For example, that might include his aunt, who is retiring in 5 years, and his sister, whose freelance business fluctuates. All three stand to benefit from timing distributions to coincide with lower-income years.
On the other hand, one cousin has the steady paycheck of a school administrator. He might be better off spreading RMDs more evenly across the 10-11 year period. That way, each year’s withdrawal is smaller, minimizing the risk of jumping into a higher bracket. And if he’s not already managing his tax liability by maxing out his 401k, tax loss harvesting, etc., this might be a good time to start.
Strategies for Account Owners
Post-SECURE Act, grandma’s heirs still have options for making the most of her bequest after she’s gone. But grandma can make an even more significant impact by optimizing her financial plan during her lifetime.
One option is to direct traditional IRA money to beneficiaries still eligible for the stretch. For example, grandma could name her brother who, at 68, is less than ten years younger.
That leaves more tax-efficient accounts for the younger crowd. Maybe that’s a Roth IRA. Or perhaps it’s appreciated taxable assets previously earmarked for charity. The heirs could get the step-up in basis while the tax-exempt charity receives the less tax-favored IRA.
If grandma is in a lower bracket than her beneficiaries, she might also want to rethink how she funds living expenses. With the stretch IRA’s demise, the common practice of tapping other assets for income to defer taxes on IRA distributions may no longer add up.
Of course, the best approach for each family depends on its unique circumstances. Younger retirement account owners might name their minor children to push out the start of RMDs. Increasing the total number of beneficiaries could also help by reducing each one’s distribution.
These strategies are only the tip of the iceberg. And it’s not just about the numbers. The more intricate the plan, the more challenging it is to explain to beneficiaries. That could create confusion and conflict that work against the best of intentions. And keep in mind: family situations and tax laws are fluid. It’s important to factor in the effort and expense to maintain the plan over the long haul.
The SECURE Act Underscores the Need for Multigenerational Planning
The SECURE Act makes estate planning more complicated for retirement account owners. That might mean children and other heirs will need more guidance at younger ages. Including them in multigenerational planning efforts could prove even more beneficial than in years past. When all is said and done, a plan that ensures a smooth, orderly transfer of assets might be the greatest legacy of all.
1 Note that, in 2020, the CARES Act supersedes the SECURE Act, and RMDs are waived.