Bloomberg Tax
Nov. 2, 2022, 8:46 AM

Eliminating the Stretch IRA Was a Mistake—Here’s How We Move On

Daniel Gilham
Daniel Gilham

The Setting Every Community Up for Retirement Enhancement Act—the most significant retirement legislation in more than a decade—went into effect in January 2021. While the SECURE Act included many positive reforms, such as allowing pooled employer plans, it also eliminated an important retirement tax and savings strategy: the stretch IRA.

Using a stretch IRA strategy, a non-spousal beneficiary of an inherited IRA (such as a child) could stretch the distributions from the IRA over their lifetime based on the age of the individual. The strategy allowed the IRA’s assets to continue growing in a tax-deferred manner. It also enabled the beneficiary to avoid a potentially massive, consolidated tax payment on the balance of the account.

In short, the stretch IRA strategy provided beneficiaries considerably more flexibility in their tax and estate planning because it allowed them to take advantage of tax-deferred growth of the IRA’s assets over a lifetime.

The SECURE Act removed that flexibility. The bill’s 10-year rule mandates that non-spousal beneficiaries withdraw the entire balance of their inherited IRA within 10 years, which is problematic for several reasons—first of which is the income taxes triggered by the new rule. Data from the National Vital Statistics System indicates that the average life expectancy of a 65-year-old is 18.5 years. Thus, on average, a retiring 65-year-old will live to 83.5 years of age, after which point an IRA would pass to the individual’s beneficiaries.

Non-spouse beneficiaries likely are in their peak earning years. In 2016, the Federal Reserve Bank of New York sponsored a study to determine the age at which lifetime incomes are highest. The study showed that most incomes peak at 45, while the top 20% of income earners peaked in their 50s. Under the 10-year rule, the tax rate that likely non-spousal beneficiaries would pay on IRA distributions is often much higher than the rate that was paid by the original owner. Under this policy change, the IRS will collect more taxes, and it will do so quickly.

The second problem deals with estate planning. Many investors fear the rapid depletion of their hard-earned dollars upon distribution to their beneficiaries. Estate planning through wills and trusts, along with the stretch IRA, allowed for spendthrift provisions.

These provisions allow the owner of assets to “control from the grave” the percentage their beneficiaries receive at specific times. Forcing the distribution of IRA assets into a 10-year window may limit that ability. Additionally, since the inherited IRA must be fully distributed in 10 years, an extended generational transition of its assets is no longer an option.

Perhaps future generations will inherit taxable assets that get a step-up in basis—adjusting an inherited asset to its fair market value on the date of the decedent’s death, minimizing capital gains taxes—and they will have no tax liability upon receiving their inheritance. But the more likely scenario under current policy is the next generation paying much higher taxes on inherited IRAs.

So, how do we mitigate the negative implications of this policy change now that it’s law? Here are three alternative strategies to consider.

First, a traditional IRA owner may want to consider a Roth conversion. If the IRA owner is retired and living on dividends and municipal bond income, this individual may sit in a lower tax bracket than their beneficiaries. By converting a traditional IRA to a Roth IRA, the owner can pay the taxes at their current, potentially lower, tax bracket and remove any tax liability from their beneficiaries. This strategy hasn’t been used in many capacities. According to Statista, of the $13.92 trillion held in IRA accounts, only $1.33 trillion is held in a Roth IRA. It’s a good time to consider such a move, however, since equity markets as defined by the S&P 500 have fallen more than 20% in 2022.

If an IRA were 100% invested in the US equity index, an investor could convert the traditional IRA to a Roth and pay over 20% less in taxes. The money would remain invested in the Roth vehicle and, as the market recovers, all gains would be outside the required minimum distribution requirements of the traditional IRA.

Second, a traditional IRA owner may want to live off their IRA assets rather than after-tax assets. This approach may create a higher income and tax rate in retirement, since all IRA distributions are taxable. However, it would allow the owner to leave after-tax portfolios to beneficiaries. This strategy also would allow the assets to grow and enable the beneficiaries to receive a step up-in basis upon inheriting the assets.

A third strategy for IRA owners is a donor advised fund, which focuses on leaving a legacy rather than maximizing the tax efficiency of a generational asset transfer. A DAF is an account that is separately operated by a 501(c)(3) sponsoring organization, from which distributions are made to another charitable organization. By naming a DAF as the beneficiary of an IRA, all distributions made from the account are tax-free. The distributions from the DAF can be made at the discretion of the family, who oversees the fund. This approach allows family members to choose the charitable causes they are most passionate about. There are no limits on when the distributions must be made, allowing the money to grow tax-free over time.

A comprehensive and generational wealth management plan is critical to each of these strategies. Working closely with a financial adviser who knows the family’s plan and the goals of each generation not only will streamline the execution of these strategies but also will ensure they are implemented appropriately—with the complete family picture in mind.

While eliminating the stretch IRA is a policy error for many American families, there are other tax and estate planning strategies that can offset the impact. Ideally, Congress would reverse course on this rule. But until then, it’s worth considering a Roth conversion, utilizing taxable assets during retirement, or naming a donor fund as the beneficiary of an IRA.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Daniel Gilham is managing director of adviser strategy at Farther. He is a former systems engineer and product manager at AOL and uses that experience to assist clients with financial planning.

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