The stretch IRA is no longer available in the wake of new legislation. But retirement account owners looking to lower the tax bill for their future heirs need not despair. A handful of estate planning strategies still exist that can potentially help families maximize their financial legacy.
While none may fully match the lucrative tax-deferral benefits of the stretch IRA, all may offer a tax-friendly pathway to meeting similar goals — such as generating income for kids and grandkids and leaving assets behind to support a favorite charity.
Those tools include:
- Roth IRA (contributions and conversions)
- Life insurance
- Irrevocable living trusts
- Charitable remainder trusts
Before exploring stretch IRA alternatives, however, it helps to review the stretch IRA as it was and how that’s changed.
The stretch IRA is gone
The stretch IRA preserved the tax-deferred status of an inherited IRA for most non-spouse beneficiaries. Under its terms, the beneficiary — typically a child, grandchild, or great-grandchild— could stretch out the annual required minimum distributions (RMDs) they would owe over their own lifetime rather than the lifetime of the original account owner.
That yielded smaller RMDs and a smaller annual tax bill, allowing those funds that remain in the IRA to potentially deliver tax-deferred growth for decades longer. By taking advantage of the stretch IRA, in fact, families could even pass down an IRA from generation to generation, extending its tax-deferred (or tax-free, in the case of a Roth IRA) status to beneficiaries along the way.
But the Setting Every Community Up for Retirement Enhancement Act, or the SECURE Act, which was signed into law by President Trump on Dec. 20, 2019, changes all that.
At its core, the Secure Act seeks to help taxpayers save for retirement by increasing the age at which RMDs from tax-deferred 401(k)s and traditional IRAs must begin and permitting working Americans to contribute to their IRA for longer, among other key provisions. (Related: What the SECURE Act means for retirees)
But it would also require certain non-spouse beneficiaries to drain an inherited, traditional IRA entirely within 10 years of the original account owner’s death, thus eliminating the stretch IRA. The justification for this move is to offset the federal budget tax loss that would result from moving back RMD deadlines. (Under the Stretch provision, the 10-year limitation on post-death distributions does not apply to individuals who are disabled or chronically ill.)The loss of the stretch IRA “opened the whole door to a lot of financial planning,” said Leon LaBrecque, chief growth officer of Sequoia Financial Group in Troy, Michigan, in an interview. “I’ve been doing this for 42 years and this was the biggest change since the Roth IRA was introduced.”
Stricter IRA withdrawal mandates for non-spouse beneficiaries affect millions of households, he said, not just the extremely wealthy.
“It really changes planning for anyone with an IRA bigger than about $400,000,” he said. “And it doesn’t just impact those with an IRA today, but anyone with a large 401(k), 403(b), a pension plan, or any other retirement asset that will eventually get rolled into an IRA. This affects regular folks.”
For example, LaBrecque recommends that pre-retirees who are still working and wish to continue contributing to their retirement accounts consider converting their traditional IRA to a Roth, which would reduce or eliminate a significant tax bill for their future heirs. (They may also be able to rollover an old 401(k) or 403(b) to a Roth if they have left that employer.)
Indeed, non-spouse beneficiaries can withdraw contributions from an inherited Roth tax-free, since the money was contributed using after-tax dollars. These contributions are either direct Roth IRA contributions or qualified converted and rollover contributions. They can also withdraw earnings from an inherited Roth tax-free, as long as the account was at least five years old when the original account owner died.
Be aware that the original account owner (you) will have to pay income taxes on any portion of a traditional IRA that gets converted to a Roth in the year the conversion takes place, because that money was never taxed.Alternatively, LaBrecque said those looking to “pre-pay” the tax on their kid’s inheritance could simply begin funding a new Roth IRA with the aim of leaving it to their heirs. The annual contribution limit for all IRAs, including both traditional and Roth, is $6,000 in 2021 ($7,000 if the IRA owner is age 50 or older). Not everyone qualifies to contribute, however. You can only contribute to a Roth if your income is less than $140,000 for singles and $208,000 for married couples. Note that the amount of allowable contribution may be limited by your modified adjusted gross income depending upon filing status. (Learn more: Retirement plan contribution limits)
“Instead of trying to leave them money when you die, you can use a Roth as part of their inheritance,” said LaBrecque.
It’s important to note that the window for completing a Roth IRA conversion may be closing. If passed, new legislation in 2021 would eliminate all Roth conversions from both IRAs and employer-sponsored plans for single filers with adjusted gross income (AGI) of $400,000 and married couples filing jointly with AGI of at least $450,000 beginning December 31, 2031.1
More immediately, the proposal would also prohibit starting in 2022 any after-tax IRA and plan contributions from being converted to Roth, regardless of income level, which would eliminate the so-called “backdoor” Roth IRA conversion and Mega backdoor conversion strategies for 401(k) accounts, according to an analysis of the legislation by IRA author and professor at The American College of Financial Services Ed Slott. A backdoor Roth IRA describes the IRA-approved practice of an individual (who would not normally be eligible to contribute to a Roth due to income restrictions) saving into a tax-deferred retirement account and then converting those dollars to a Roth.
The life insurance approach
Retired couples who do not need the annual minimum distributions they are required to take from their IRA may have another option — one that could potentially boost the overall impact of their IRA.
Retirees could potentially use a portion of their required minimum distributions (RMDs) to purchase a life insurance policy, said Greg Hammond, a financial professional with Hammond Iles Wealth Advisors in Wethersfield, Connecticut.
“This strategy can be used by individuals of any age to increase the impact of their retirement funds and reduce the tax burden on their future heirs while paying less in income and estate taxes,” he said in an interview.
To illustrate, a hypothetical couple with a $1 million IRA might be required to take roughly $40,000 in RMDs each year starting at age 72 . They would owe roughly $13,000 in deferred income tax and use nearly $20,000 to pay annual premiums on a new $1 million second-to-die life insurance policy that pays out to the beneficiaries (children or grandchildren) income tax-free after the death of the second policy owner. The unused portion of the RMD (roughly $6,000, in this case) would be the account owner’s to use however they choose.
If either their children, another beneficiary, or an irrevocable trust owns the life insurance policy, the death benefit falls outside of their taxable estate and is not subject to estate taxes, making the proceeds both income and estate tax-free.
Hammond cautioned that premiums paid to children or other beneficiaries are considered gifts and may be subject to gift tax unless the amount falls below the federal annual gift tax exclusion amount ($15,000 per person in 2021). Married couples can combine their annual exclusion amounts and gift $30,000 per year without incurring a gift tax liability.2 A gift tax return should be filed when a married couple chooses to gift split.
At the same time, the original IRA account (less any RMDs that are taken) remains invested and continues to generate growth, with the spouse still named as the primary beneficiary. If the spouse outlives the account owner, he or she can continue to receive annual distributions from the IRA. Since the couple replaced the value of the retirement account with a life insurance policy that will benefit their heirs, they can consider naming one or more charities as contingent beneficiaries of the retirement account itself, which would receive the entire balance of the IRA tax-free after both spouses have passed away.
“This ‘double impact’ retirement account strategy uses distributions from a retirement account to pay for a life insurance policy owned outside of the individual’s taxable estate, thereby leaving an income and estate tax-free inheritance to their future heirs,” said Hammond. “Both the heirs and the charities receive the benefit of the planning, while potentially avoiding taxes.”
An extension of this life insurance strategy could also replicate the regular, flexible payments of a stretch IRA. Retirement account owners (especially those with larger IRAs and large taxable estates) could opt to fund an irrevocable trust with a life insurance policy, said Scott Bishop, vice president of financial planning with STA Wealth Management in Houston, Texas.
Under this approach, he explained in an interview, the IRA owner would create a trust for the benefit of his or her family and purchase a life insurance policy inside the trust. The IRA owner would then take distributions from the IRA and make gifts to the trust that would be intended for the annual premium payments on the life insurance policy long before their death, perhaps when they’re in their 60s. At death, the life insurance policy’s death benefit would fund a trust that is set up to pay a regular income stream to beneficiaries.
Growth in the trust would be tax-deferred, said Bishop, and the life insurance proceeds would be income tax-free and estate tax-free if structured properly. The trust could then be structured to allow for flexible distribution amounts similar to a stretch IRA. Plus, payments potentially can be spread out over decades, as long as there is money in the trust, as opposed to just 10 years or less.
LaBrecque said he, too, is suggesting to most of his clients in the wealth transfer zone that they consider an irrevocable living trust, or a revocable trust that becomesirrevocable on the death of the last spouse, which gives them discretion over how the inheritance gets distributed. By leaving an income stream instead of a lump sum, he said, beneficiaries are less likely to fall victim to “sudden wealth syndrome,” a common scenario in which many who receive a large lump sum fritter away their found money frivolously. (Learn more: Entering the wealth transfer zone)
Naming a trust as the beneficiary of the IRA, he added, also can protect those funds from creditors in the event your heirs should experience financial troubles or even bankruptcy down the road.
But trusts can be costly and complicated. Be sure you discuss the pros and cons of any estate planning vehicle you are considering carefully with a trusted financial professional or legal advisor. (Related: Is setting up a trust right for you?)
Charitable remainder trusts
Those who wish to support their loved ones financially, save taxes, and benefit a favorite charity might instead use a portion of their IRA to fund a charitable remainder trust that names a non-spouse beneficiary, said Bishop.
“The asset owner could create and fund the trust with IRA assets at death, and beneficiaries would get a regular income stream from the trust, similar to the required minimum distributions from an inherited IRA, which could be distributed over a certain amount of time or the beneficiary’s lifetime,” he said. “The assets are only taxed when they leave the trust.” The deduction is claimed by the estate of the original IRA owner at the time the charitable remainder trust is created. The longer the period for the stream of payments, the less the tax deduction, so the term of the trust should be considered and coordinated with the IRA owner’s family goals and objectives.
Then, when the beneficiary dies, or the term of the trust expires, the trust’s remaining assets would go to a designated charity tax-free.
Consult a professional
With the demise of the stretch IRA and other retirement rule changes, those in the wealth transfer zone may wish to connect with their financial professional, estate planning attorney, or tax professional to determine which alternative estate planning tools may be best suited to help them meet their financial goals. (Need financial advice?)
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This article was originally published in October 2019. It has been updated.
1 Internal Revenue Service, “IRA FAQs – Contributions,” August 18, 2021.
2 Internal Revenue Service, “Frequently Asked Questions on Gift Taxes,” July 30, 2021.