23 Oct Look out taxes, ‘Stretch IRAs’ might go away

Q. A financial advisor told me that Congress is planning to end the “stretch” period for IRAs inherited by someone other than a spouse, requiring liquidation either immediately or within five years rather than stretching over the life of the beneficiary. That makes tax planning very difficult. Is that part of the proposed tax plan?
— Planning

A. So called Stretch IRAs allow for interesting planning opportunities for both the beneficiary and the grantor.

Let’s take a closer look.

Under current law, a Stretch IRA is a way to limit Required Minimum Distributions (RMDs) on an IRA inherited by a non-spouse beneficiary, avoiding the tax consequence of liquidating the entire IRA in one shot or over a five-year period, said Matthew DeFelice, a certified financial planner with U.S. Financial Services in Fairfield.

“Instead of naming his or her spouse as the IRA’s beneficiary, an account holder can name children, grandchildren or great-grandchildren,” he said. “This stretches the lifespan of the IRA, extending its tax-deferred status across multiple generations for years or decades beyond the life of the original owner.”

DeFelice said the Stretch IRA takes advantage of the fact that younger beneficiaries will have smaller RMDs. He said Stretch IRAs work most efficiently when account holders name their youngest relatives as beneficiaries — that is, assuming your spouse has enough money to live on without that account.

Because RMDs are based on the IRS’ tables for life expectancy, they are calculated by dividing the account balance by the account holder’s anticipated lifespan, DeFelice said.

The younger you are, the lower your RMDs, so those younger relatives can then take RMDs that are small enough to trigger minimal taxes while the bulk of the account can continue to enjoy tax-deferred compound growth, he said.

“If you’re not comfortable bypassing your spouse as your IRA beneficiary, they can simply roll your IRA into an inherited IRA in his or her name with the younger relatives as beneficiaries,” he said. “When your spouse dies, the young beneficiary simply starts taking the smaller RMDs based on their life expectancy.”

Simply put, the ability to stretch an inherited IRA could make a difference of hundreds of thousands, or even millions, of dollars over a beneficiary’s lifetime.

Unfortunately, many experts believe the days of the Stretch IRA are indeed numbered.

The Finance Committee’s proposed bill, called the Retirement Enhancement and Savings Act, would require beneficiaries of an inherited IRA to pay all taxes due on the account within five years of the owner’s death, DeFelice said.

“The bill does contain a $450,000 exclusion for non-spousal beneficiaries,” he said. “That means an inherited IRA worth $1 million would be taxed only on $550,000.”

DeFelice said we will have to wait and see if and when the final bill is passed before doing any serious tax planning, but there will certainly still be some opportunity for savvy individuals.

He said the current proposal states that each IRA owner is entitled to exclude $450,000, but an unused exclusion can’t be transferred to a surviving spouse. So if you simply leave everything to your spouse, the family will only get to exclude $450,000 from one spouse instead of $900,000 combined.

“This knowledge should serve as a wake-up call to married couples who have a lot of money in retirement accounts, who should make sure they each have their children/grandchildren as direct beneficiaries of up to $450,000 of retirement assets,” he said. “If the bill passes, it would seem that whenever possible it makes sense to take advantage of both exclusions — otherwise, you will lose the opportunity for some enormous tax savings.”

But of course, at this point all, we can do is wait and see how things shake out, and once we know the final specifics we can plan accordingly.

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The post was originally published in October 2017.