President Obamas budget proposals for the 2016 fiscal year once again called for the elimination of the stretch IRA. It may not happen this year, but sooner or later it is likely to be enacted.
Under the latest proposal, the stretch IRA, which provides a lifetime payout to IRA beneficiaries, would be replaced with a mandate that the payout be limited to five years. This might seem to be a blow to beneficiaries. In fact, however, financial advisors and their clients should be able to find alternative approaches that are at least as attractive.
As it stands now, the stretch IRA rules allow beneficiaries to extend required minimum distributions on inherited IRAs over their lifetimes, maximizing the value of their inheritance and keeping income low by taking only the minimums each year.
Congress created the IRA in 1974 as part of the Employee Retirement Income Security Act; it took effect the next year. The goal, in part, was to enable individuals to own actual retirement funds.
At that time, many companies that offered pension plans did not keep their pension promises because of bankruptcy or shady bookkeeping, or failure to meet pension financing obligations. In some cases, employees who had earned benefits were left with little or nothing for their retirement years.
In 1972, the problem drew national attention after NBC News highlighted the issue in a segment titled Pensions: The Broken Promise. The Pension Benefit Guarantee Corp. was established by ERISA to insure workers pension benefits.
At the time, Congress was worried about workers having enough; it probably never considered the possibility that IRAs could grow so large that there would be balances left over for beneficiaries. By now, however, the IRA has come to be an estate planning vehicle for some owners.
In light of this marked change, it seems likely that Congress will see no problem eliminating the stretch IRA.
Theres another factor at play. The U.S. Supreme Court recently ruled unanimously that once a beneficiary inherits an IRA, the account is no longer considered a retirement fund for federal bankruptcy protection. Even the Supreme Court does not view an inherited IRA as a retirement account.
Given all this, the fate of the stretch IRA is probably in jeopardy.
But that presents a silver lining for financial advisors because additional planning could leave clients with better and less complicated options.
The government predicts billions in new revenue from the elimination of the stretch IRA, but it is possible that the government will actually be a loser in the long run. Ending the stretch IRA could stop older people from converting large IRAs into Roth accounts for their children and grandchildren. Why would a 70-year-old pay the tax to convert if the grandchilds tax-free stretch Roth IRA period could be cut from decades to just five years? It wouldnt be worth it.
Another unintended consequence could be that more IRA money would be withdrawn and leveraged into tax-free vehicles like life insurance, which is even better for heirs than a stretch IRA.
Turning IRAs into tax-free life insurance policies would bring in short-term cash on upfront IRA withdrawals, but could cost the government a fortune in long-term tax revenues lost to good tax planning. The clients, their beneficiaries and, in turn, advisors will be the big winners here.
Life insurance has three major advantages over the stretch IRA for clients and their beneficiaries:
- Distributions to beneficiaries will be tax-free. Even though an inherited IRA can be stretched, the distributions are generally taxable (except for an inherited Roth IRA). But life insurance distributions are income tax-free. And while IRAs (including Roth IRAs) are always included in the estate, life insurance can be set up outside the estate, free of estate taxes as well as income tax.
- Life insurance is not subject to RMD rules. Inherited IRAs are subject to RMDs, whether the beneficiary needs the funds or not, creating a tax bill each year. Inherited IRAs are also subject to confusing and tricky tax rules. Life insurance does not have complex distribution rules or tax obstacles.
- Life insurance is more trust friendly. If clients want to make sure an inherited IRA is not squandered by beneficiaries, they usually have to set up a trust and make that trust the IRA beneficiary. Even if the trust is done perfectly, high taxes may occur on the IRA distributions that end up being taxed in the trust. Life insurance is a better asset than an IRA to leave to a trust. The insurance proceeds paid to the trust will be tax-free. The insurance can be distributed to the beneficiaries or remain in the trust for their benefit, according to the clients wishes. These benefits provide post-death creditor protection for heirs, in addition to the tax savings and leverage.
Life insurance is not the only alternative to the stretch IRA available to the resourceful planner. A charitable remainder trust can simulate the stretch IRA by allowing annual payments to beneficiaries over their lifetime or for a specified number of years.
CRTs can also control inherited IRA funds to protect them from being squandered or lost by beneficiaries through divorce, lawsuits or other financial problems. Moreover, these trusts can protect unsophisticated beneficiaries from bad judgment, from poor investments or from being taken advantage of financially. Clients like this.
Finally, CRTs are tax exempt, offering both estate and income tax savings. The estate gets a federal estate-tax deduction for the present value of the eventual charitable contribution. (The longer the payout to beneficiaries, the lower the value of the estate-tax deduction.) And no income tax is owed on the distribution from the IRA to the CRT after death. Beneficiaries pay ordinary income tax on the CRT payouts, but would be taxed anyway on direct distributions from the IRA and that tax would be accelerated if inherited IRAs were subject to a five-year rule.
Remember, though, that after death, CRTs are irrevocable. Once the IRA funds are inherited by the CRT, they cannot go back to a beneficiary, other than as annual payouts from the trust. Unlike with an IRA, beneficiaries cannot request additional sums when needs arise. They can receive only the annual CRT distributions.
To qualify for the estate-tax deduction, at least 10% of the present value of the IRA must end up with the charity. Over a number of years and under certain conditions, beneficiaries may still end up with more money through the guaranteed distributions from the CRT than with a stretch IRA. An early death of the beneficiary would leave more funds to the charity, however.
One final point: Dont leave a Roth IRA to a CRT (or to a charity). The tax has already been paid on these funds by the account owner. There is no tax benefit here.
Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer and an IRA distribution expert, professional speaker and author of several books on IRAs. Follow him on Twitter at @theslottreport.
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