There is currently a bill in the Senate designed to help more Americans save for retirement. While the Setting Every Community Up for Retirement Enhancement (SECURE) Act does pose a few regulations to help the average American do exactly that, there’s one provision that has alarm bells ringing. (If yours aren’t yet, they should be.) Because we are talking about the call to eliminate the stretch benefit of inherited IRAs.
Editor’s note: The SECURE Act passed into law on December 20, 2019, after the publication of this article. Consult your tax professional for details of the law that were passed and/or excluded from the initial bill.
It would appear to some (including us) that this provision is nothing more than a back-door effort to recoup what opponents call a “new and improved inheritance tax.” Because, make no mistake: This is a clever move with the sole purpose of the IRS getting their hands on more of your money.
And by eliminating stretch IRAs, they’ll get that money quickly—to the tune of as much as one-third more of the funds in that retirement plan than they can take now under current law.
Your alarm bells ringing yet? Read on…
What Is a Stretch IRA?
For decades, stretch IRAs have been an effective and appreciated estate planning tool for our parents and grandparents to pass the fruits of their hard-earned wealth on to children or grandchildren. Currently, if you inherit an IRA, the required minimum distributions (RMDs) are recalculated based on your projected life span. You’ll take those RMDs annually, and the balance of the IRA remains intact and generating tax-free income for the duration. Compounding interest plays a roll, as well, and can significantly increase the account’s value over your lifetime.
While detractors (who want your money anyway) call this way of planning a scheme for the wealthy—who cares? The wealthy have every right to decide what to do with money they have spent their lives amassing. We all do.
But, guess what? Eliminating the stretch IRA doesn’t just affect the wealthy elite. It affects anyone who inherits an IRA. And, that includes your middle-class American who will, again, take a beating from the government by way of taxation. Here’s how…
The Death of the Stretch IRA
The SECURE Act would effectively kill the stretch IRA and impose what some call a death tax on non-spouse beneficiaries (i.e., your children)—giving them 10 short years to withdraw all funds from inherited IRAs and 401(k)s. Yes, the government’s doubling down to get at your money, because as Uncle Sam snatches a fairly large portion of that inheritance, your children get bumped straight up into a higher income-tax bracket, too. In essence, the IRS becomes a not so honorary beneficiary of your IRA or 401(k).
This spells disaster for anyone who has worked a lifetime to save money in an IRA to leave to their children or grandchildren. Actually, the disaster falls upon those beneficiaries who will be taxed to kingdom come depending on what their annual income already is. And if they live in a state with high taxes? Forget it. More than half of that annual distribution can go towards taxes.
To put this in perspective—currently if you inherit an IRA, you could expect the compound earnings and investments in the account over your own lifetime to be significant. If the stretch is eliminated and depending on your age when you inherit, you can potentially miss out on a sizable amount of additional earnings over your lifetime. And, we repeat, on top of that loss, you’ll be taxed pretty heavily on those 10-year distributions. (Read that again.)
But that’s not all.
If parents of college-aged children inherit a substantial IRA, having to take fairly large annual distributions over 10 years can affect their ability to receive financial aid for tuition. While they can postpone taking a distribution until the 10th year to avoid this, doing so means taking the entire tax hit in one single year.
Now, the SECURE Act exempts spouses from that 10-year rule, but the act also proposes to extend the age for RMDs from 70 ½ to 72 years of age. Sounds beneficial at first. But, there’s a caveat. A widow pays the higher taxes of a single filer (about 12-25%). But, that taxable income bracket increases to about 24-36 percent because the RMD payout percentage adjusts with age. So, at 70 your RMD is about 3.7 percent of the balance of the retirement plan. At 90 the payout is 8.8 percent. And, the longer you have to take RMDs, the larger that distribution is—again, impacting taxable income if the life expectancy tables aren’t changed.
Your Takeaway on The SECURE Act
There are additional provisions in the bill that may also apply to you. But we will have to wait until the bill passes the Senate and becomes law to find out specific details. Discuss the potential impact this act may have on your existing retirement accounts with your tax professional and consider alternate estate-planning strategies if your desire is to leave income to your children when you’re gone.
In the meantime, to learn how your self-directed IRA or 401(k) funds may be affected for your beneficiaries, please contact Advanta IRA.