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Legislation that will help workers save for retirement could also have a chilling effect on a strategy to pass individual retirement accounts on to heirs.
The bill, known as the Secure Act, sailed through the House on May 23. Legislators on both sides of the aisle voted in favor of it, 417 to 3.
This legislation not only makes it easier for small employers to pool together resources to sponsor 401(k) plans, but it also repeals the maximum age of 70½ for contributions to traditional IRAs.
However, those enhancements come at a cost.
There’s a revenue provision tucked in the bill that would require most non-spouse beneficiaries to zero out inherited IRAs within 10 years of the original owner’s death.
This chills a tactic that wealthy owners use to pass on large retirement accounts and save on taxes, known as the “stretch IRA. “
In this strategy, younger heirs — your kids and grandkids, for instance — can take required minimum distributions from the inherited IRA based on their own longer life expectancy.
As a result, these heirs can “stretch” the IRA’s tax-deferred growth for many years while taking those small distributions.
“The stretch gave you benefits without making much of a trade-off,” said Jeffrey Levine, CPA and CEO of BluePrint Wealth Alliance in Garden City, New York.
“The question is now, ‘Are we comfortable with everything in this IRA going to the kids in a 10-year period?'” he asked.
Stretching an IRA
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Under current law, if you inherit an IRA from someone who isn’t your spouse, you’re generally required to start taking minimum distributions calculated on your life expectancy by Dec. 31 after the year the original account owner died.
The House bill would force a distribution of the account’s value within 10 years.
A similar bill making its way through the Senate, the Retirement Enhancement and Savings Act of 2019, would distribute the account in five years if the beneficiary is not a spouse and if the account value exceeds $400,000 as of the date of death.
Both bills make an exception if the beneficiary is the surviving spouse, a disabled or chronically ill person, an individual who is no more than 10 years younger than the account owner or the minor child of the account owner.
Preserving tax deferral
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The stretch IRA is most beneficial to young heirs of large accounts. These people have years of tax-deferred growth ahead of them, and they only need to take a small distribution each year.
For example, based on current law, a 22-year-old who inherits a $1 million IRA as a non-spouse beneficiary would be on the hook for an RMD of $16,400 or 1.64% of the account’s value that first year, said Levine.
That distribution is subject to income taxes.
If you fast-forward 18 years, that beneficiary is then 40 years old. That year, he is responsible for a distribution of 2.32% of the value of the IRA, Levine said.
“We’re still talking about an exceptionally small percentage of the account that must be distributed each year,” he said.
On the other hand, an accelerated distribution of the account over a much shorter period would result in a large tax bite, Levine said.
Other methods emerge
Tax experts are looking at a couple of alternative strategies that IRA owners might consider to minimize taxes while passing on the account to a non-spouse heir, if the bill passes.
• Charitable remainder trusts: These trusts allow investors to leave assets to a charitable organization and to a beneficiary.
Your beneficiary would collect a stream of income from the assets for a specified time span. At the end of that period, the charity collects whatever is left.
“The distributions are made during the term of the trust to the individual, and you can get the stretch benefit there,” said Suzanne Shier, chief tax strategist at Northern Trust in the greater Chicago area.
“It’s for people who have charitable motivations, a tax minimization motivation and an appetite for the complexity of charitable trusts,” she said.
To make this work, you would have to name the trust as the beneficiary of the IRA, a move that can be a tax minefield if done incorrectly. Make sure you coordinate with a CPA and an estate planning attorney if you’re considering this route.
• Life insurance: “With life insurance, you could get more money tax-free without any RMD or complexity, and just bypass the whole system,'” said Ed Slott, CPA and founder of Ed Slott and Co. in Rockville Centre, New York.
Generally, the death benefit of a life insurance policy is excluded from the recipient’s gross income. Your premium dollar also goes further.
“If you have $100,000 in an IRA, it’s just $100,000,” said Slott. “But if you’re spending $100,000 on life insurance, that might be worth $500,000 in death benefits.”