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New Stretch IRA Rule Could Cost Your Kids Thousands
One provision of the recently passed SECURE Act is the abolishment of a popular estate planning strategy known as the Stretch IRA. As of 2020, when an IRA (401k & Roth included) is inherited, the beneficiary has to distribute the entire IRA within 10 years of the date of death. That means the IRA has to be fully taxed within 10 years and the tax-deferred compounding ends. You won’t be able to “stretch” the distributions over your lifetime – as allowed previously.
There are some exceptions. The 10-year distribution requirement doesn’t apply to a beneficiary who is a surviving spouse, disabled person, a chronically ill person, a minor child or someone fewer than 10 years younger than the original IRA owner.
How costly is this rule?
In short, the new rule greatly accelerates tax collection and can push beneficiaries into a much higher tax bracket. For instance, let’s say you’re 50 years old, in your peak earnings of your career and you inherit a $1M IRA from your parent in February 2020. Let’s also say your life expectancy according to IRS tables is 85 years old.
Before the SECURE Act, you were able to spread the distributions over 35 years – from your age 50 to your life expectancy age of 85 – taking roughly $28,500 each year. The impact of this on your taxes could be minimal, particularly after retirement when your taxable income might be lower.
Now, look at the same situation after the SECURE Act. You must take the entire $1M inheritance in the next 10 years. If you choose to take even distributions, this will translate into ~$100,000 additional income each year. Assuming you’re at the peak of your career and will continue to remain in high-income tax bracket the next 10 years, you’re likely to pay significant tax dollars on your inherited IRA distributions.
What do you need to consider?
The elimination of the Stretch IRA may force many to revisit their retirement and estate plans to consider alternative strategies to reduce their provisional income and tax liability in the event of an inheritance. Here are a few things to consider under the new rule:
1. Tax diversity becomes more important.
The ability to save money pre-tax for retirement is powerful. But we’ve long advised savers not to put all their eggs in one tax basket. Having money saved in Roth IRA’s and outside of retirement in ordinary savings and investment accounts is also important. The elimination of the Stretch IRA makes it much more appealing to inherit money in a non-taxable account or from a Roth IRA. If you’re maximizing contributions to your 401k, it might be worth considering dialing back those contributions to the employer match level, and making Roth contributions instead. If you don’t qualify for Roth contributions due to your income level, you may be able to do so through cash-value life insurance or “back door” Roth contributions.
2. Roth Conversions become more appealing.
Converting money from a traditional IRA or 401k to a Roth IRA has often made financial sense – but this change will make the strategy even more appealing. Roth IRA’s will also (presumably) need to be distributed within 10 years of death, but at least there will be no immediate tax impact to the heirs. We still can’t see converting pre-tax funds in the highest tax brackets, but with today’s lower rates and these new rules, it will make sense for many more people.
3. College planning turned on its head.
Many people inherit money at about the time that kids are heading off to college. If you inherit a sizable IRA prior to applying for financial aid, you may find yourself with a real Hobson’s choice. Either take annual distributions as permitted over 10 years and likely disqualify yourself from financial aid due to your (temporarily) higher income, or wait until the kids are done with college and take a really large distribution all at once (forcing all the income to be taxed in the highest brackets).
If you or your family are facing any of these topics as we proceed into 2020, we highly encourage you to set up some time so we can discuss your personal situation. There are substantial planning opportunities that exist, but it is critical to be proactive vs reactive.
To schedule a time to discuss your financial future and the possible role of insurance or investments in your financial strategy, contact us or call us at 502-632-3624 today!
We are an independent retirement planning and CPA services firm helping individuals create retirement strategies using a variety of investment and insurance products to custom suit their needs and objectives.