Will We Say "So Long" to Stretch IRA's?

Cary, NC Estate Planning Attorney

Cary, NC Estate Planning Attorney

While everyone (myself included) was writing about the Estate Tax and its apparent impending doom, the United States Senate Finance Committee was quality voting 26-0 to end Stretch IRAs for non-spouse beneficiaries. 

Mind blown. Where did that come from? First, what is a Stretch IRA and why does it matter?

What is a Stretch IRA anyway?

Traditional IRAs are a tax-deferred retirement investment vehicle, meaning individuals can contribute to them with "pre-tax" dollars and defer the income tax on those dollars until retirement. They would then take distributions from the IRA as taxable income. Prior to retirement, though, the assets in the IRA can be invested and the investments grow tax-free (i.e., no capital gains or income tax while the assets are in the IRA). 

When someone dies with assets still held in an IRA (i.e., their retirement account outlived them), the person designated on their "beneficiary designation" will receive the benefit of the IRA assets. If there is a surviving spouse, the spouse can roll the balance into their own retirement account and continue to grow the assets tax-free until they reach the age of 70 1/2, which is when "required minimum distributions" (RMDs) must be taken (the minimum amount which must be withdrawn as income each year, calculated based on the person's age). If the beneficiary is a child or someone else other than a spouse, the IRA can be transitioned to an Inherited IRA in the beneficiary's own name and the beneficiary can continue to defer the tax until their own retirement (or age 70 1/2, which happens sooner). So, currently the assets in an IRA can grow through almost two full generations of investments without having to pay capital gains or income tax on the growth. This can be an effective way to pass on generational wealth from parents to children. 

What if the Stretch IRA goes away?

That generational deferral of income tax, and avoidance of capital gains tax, does away. If a parent passes away and leaves their child, as beneficiary, a large IRA balance, the child will no longer be able to continue to defer the tax ("stretch out" the growth), and will be forced to pay the full income tax liability within five (5) years of the IRA plan owner's death. Spouses will still be able to roll over the IRA into their own tax-deferred retirement account, but non-spouse beneficiaries cannot. This could have substantial tax and estate planning implications for most families in America. 

What other options are there?

Some families will opt to withdraw "unneeded" funds from their own IRA's and fund other tax-free investment vehicles, like life insurance. If a parent has much more money in their IRA than they'll need for retirement, they may opt to just pay the early withdrawal penalty (if any) and income tax, and use that money to pay for an annuity or life insurance premium for a much larger amount, all of which is paid tax-free as a proceed of death. For example, a parent could withdraw $300,000 in IRA cash, pay the penalty (if any) and income taxes and use that amount to purchase a $1,000,000 in life insurance, which will pay to the proposed beneficiary with zero tax liability (subject to any applicable estate taxes on the decedent's estate, generally). 

Of course, this article is not meant to be, and shouldn't be taken as, investment or legal advice and, this article relates to an expected outcome in 2017 - the changes referenced herein are proposed and not final. 

Always speak with a financial advisor and estate planning lawyer before making investment or legal decisions.