Congress Does Away with the Stretch IRA
Article Highlights:
- Taxability of Distributions
- Stretching Distributions
- SECURE Act Changes
- Ten-Year Rule
- Spouse Exception
- Other Exceptions
- Naming Beneficiaries
Some members of Congress have, for some time, expressed their displeasure with the so-called stretch IRAs that have permitted some beneficiaries, such as a young child or a grandchild, to extend the payout period from the IRAs they inherited for decades.
When someone inherits an IRA or retirement plan, with the exception of a Roth IRA, the distributions from the retirement plan are generally taxable to the beneficiary. In the past, beneficiaries have often been able to use a lifetime distribution option to stretch the payments over a long period of time, growing the account with deferred earnings and lessening the overall taxes on the distribution. If the beneficiary is the decedent’s spouse, the spouse has special options for a lifetime payout or the ability to treat the plan as their own plan and defer distributions until they reach the age when distributions are required to begin*.
Prior to the passage of the SECURE Act (part of the Appropriations Act noted above), individuals had complicated options that included, in some cases, being allowed to stretch the taxable distributions from a retirement plan or inherited IRA over their lifetimes.
With the passage of the SECURE Act, and for distributions from retirement plans or IRAs of individuals dying in 2020 or later, the ability for some beneficiaries to stretch the distributions has been rescinded and replaced with a requirement to withdraw all the funds by the end of a 10-year period beginning the year after the plan owner’s death. This will no doubt require some tax planning to mitigate the taxes on the distribution. Should the account’s heir wait until the end of the 10 years to withdraw the funds, take one-tenth of the account each year, or adjust annual distributions to match fluctuations of their other income? Each person’s situation is unique and will require analysis to determine what the best payout plan is for them.
The SECURE Act does include the following exceptions to the 10-year distribution period:
Spouse - In the case of the surviving spouse of the decedent, the spouse continues to have the options to treat the plan as if it were theirs and defer distributions until the surviving spouse reaches the required distribution age*, take distributions over their lifetime, or take the distributions within 10 years of the decedent’s date of death.
Minor Child - If a minor child is the beneficiary of the deceased’s retirement plan or IRA, the entire account must be distributed within 10 years after the year the child reaches the age of majority. In the U.S., the age at which a child reaches majority (i.e., is considered an adult) is determined by each state, with age 18 being the most common age.
Individual Fewer than 10 Years Younger, Disabled or Chronically Ill - For any individual beneficiary who is not more than 10 years younger than the deceased (for example, a sibling or a friend) or is disabled or chronically ill, the retirement plan or IRA account balance generally may be distributed (similarly to pre-Act law) over the life expectancy of the beneficiary, beginning in the year following the year of death of the deceased retirement plan or IRA owner.
The issue of naming a trust as the beneficiary of an IRA comes up regularly. There is no tax advantage to naming a trust as an IRA beneficiary. Of course, there may be a non-tax-related reason, such as controlling a beneficiary’s access to money; naming a trust rather than an individual(s) as the beneficiary of an IRA could achieve that goal.
Generally, trusts are drafted so that required distributions from the IRA will pass through the trust directly to the individual trust beneficiary and, therefore, be taxed at the beneficiary’s income tax rate. However, if the trust does not permit distribution to the beneficiary, then the distributions will be taxed at the trust level, which has a rate of 37% on any taxable income in excess of $12,750 (2019 rate). This high tax rate applies at a much lower income level than for individuals.
If you have a trust set up to receive IRA distributions, you should consider having your legal advisor review this arrangement in light of the recent law changes.
To ensure that your IRA will pass to your chosen beneficiary or beneficiaries, be certain that the beneficiary form on file with the custodian of your IRA reflects your current wishes. These forms allow you to designate both primary and alternate individual beneficiaries. If there is no beneficiary form on file, the custodian’s default policy will dictate whether the IRA will go first to a living person or to your estate.
It may be appropriate to consult with this office regarding your particular circumstances before naming beneficiaries; also, call if you have questions about the new inherited IRA and retirement plan distribution rules.
*Effective for tax year 2020, for living IRA and retirement plan owners, the age for required minimum distributions increases from age 70½ to age 72, but only for taxpayers who turn 70½ after December 31, 2019.
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