December 20, 2019

Edited 05/14/20

Inherited IRA Planning Tips with SECURE Act Eliminating Stretch IRA

Recent legislation has brought about major potential changes to inherited IRA retirement strategy for many Americans. The SECURE Act promises to be among the most prolific retirement legislative changes we have seen in more than a decade. In this article, you will find how inherited IRA and updated RMDs provisions in this legislation could impact your retirement and estate plans.

No free lunch: Inherited IRAs have new rules

All of the benefits of the SECURE Act come at a cost and the cost for this provision will be paid for by the essential elimination of a popular wealth transfer strategy associated with inherited IRAs.  Known as the ‘stretch IRA,’ it is a technique where beneficiaries of an IRA can stretch the IRS mandated required distributions over their lifetime—giving them more time for tax-deferred savings.  

Previously with a stretch IRA, beneficiaries selected were typically younger and therefore the amount taken from the accounts were greatly reduced. This allowed for additional tax-favored growth of the balance that remained in the account. Some have named their grandchildren or great-grandchildren as account beneficiaries to even further reduce the required distribution that accompanies the inherited traditional or Roth IRA assets. Now the SECURE Act eliminates stretch IRA, but it provides a delay of RMDs which can allow the account value to increase for beneficiaries.

The Benefits of Delaying Required Minimum Distributions (RMDs)

The SECURE Act helps IRA account holders increase their savings by adjusting the age requirements for RMDs. The ability to delay RMDs can go a long way to preserve the account balance for a spouse and ultimately their beneficiaries because the account balance will likely be higher in the inherited IRA.

Previously, the law required people to withdraw at age 70.5. Now, savers have until the age of 72 before being forced to withdraw. In addition to delaying the age requirement, they can also continue to contribute beyond the age of 70.5. This is great news for savers and those that will soon be facing the dreaded RMD. The power of tax deferral allows account holders to have more time and more opportunity to save. By delaying the withdrawal requirement, savers’ accounts will continue to grow which will ultimately make their savings grow as large as possible for them and their heirs. 

Tip #1: Consider Your Spouse First As Your Beneficiary 

With an inherited IRA, it previously was logical to select a beneficiary that was younger than your spouse. Especially if your spouse was not dependent on the income in your IRA account and the money was ultimately going to be passed to the next generation.  

With the passage of the SECURE Act, this could be a good time to reconsider that strategy. Naming a spouse as the primary beneficiary of your IRAs instead of a non-spouse will allow them to continue tax-favored growth without having to follow the aggressive 10-year timeline for withdrawals. Although they are still subject to RMDs from that account based on their life expectancy, those withdrawals will likely be less than what would be required under a 10-year withdrawal plan.  

The surviving spouse would then pay tax on the withdrawal and could use that income to make gifts to their heirs while living. The surviving spouse could also take the withdrawal and use the income to contribute to a taxable account that would receive a step-up in cost basis at the time of their death, leaving their heirs with an account largely free of any tax consequence.

Consider and compare these two inherited IRA strategies for spouse vs. non-spouse:

  1. A 67-year-old inherits a traditional IRA from their spouse in the amount of 1 million dollars.  The account is assumed to earn 5% and their tax rate is assumed to be 12%. They live for 10 years and begin to take required withdrawals at age 72. At age 77 they die and pass the remaining IRA assets to their 55-year-old child. The child has an assumed income tax rate of 24% and must begin taking withdrawals from the account so the account can be depleted in 10 years. This results in total income from the account of $1.5 million.
  2. A 45-year-old child inherits a traditional IRA from their parent in the amount of 1 million dollars. The account is assumed to earn 5% and they are currently in the 24% tax bracket. They must begin withdrawals immediately and the account must be fully depleted in 10 years. The total amount of income generated from the account is approximately $1.2 million.  

Net net: Under the new legislation, rethink your plans for inherited IRAs. There is often a significant benefit to naming a spouse as a beneficiary and then allowing that asset to be passed to the next generation versus giving it directly to the child.

Tip #2: Converting Your Traditional IRA to Roth

While this question has been a consideration for retirees for some time it may now require additional thought. With the SECURE Act, the delay in RMDs will likely result in larger account balances which could mean more tax liability upon withdrawal.

The transfer of wealth to the next generation through inherited IRAs is likely to face a significant amount of additional taxable income. Especially if those beneficiaries are already in their peak earning years. While a spousal beneficiary may not be impacted by the decision to convert or not, it is likely that those that inherit an IRA will be impacted. Thinking about whether to convert your traditional IRA assets to Roth? You should consider your current tax bracket as well as your beneficiary.   

Passing on a Roth account has typically been a favored way to pass money to the next generation.  Now that the income schedule has accelerated for beneficiaries it may be even more advantageous to pass along Roth assets as opposed to traditional assets.

Inherited IRA Planning Next Steps

The passage of new retirement legislation in the SECURE Act will go a long way in helping savers and retirees from outliving their income. It does come at a cost and if you have inherited IRAs as part of your wealth transfer plan now is the time to reconsider the named beneficiaries of your IRA. It is also a good time to consider if you should begin the conversion of your traditional IRA assets to a Roth.