Stretching an individual retirement account refers to the practice of sustaining the tax-deferred status of an inherited IRA for as long as possible when the beneficiary is someone other than a spouse (typically, a child or children). 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.
We now have compelling evidence that a law will pass, probably this year, putting an end to this useful tool. Here’s some advice on what advisors should be doing about it and steps to take if the law passes.
The Proposal
The Finance Committee’s proposal establishes that subject to some exceptions that are discussed below, beneficiaries of inherited IRAs must withdraw and pay income taxes on the entire IRA within five years of the IRA owner’s death. This action accelerates income taxes and will likely push the beneficiary into a higher tax bracket during the distribution years. Though the distributions from Roth accounts won’t be taxable, all further interest, dividends and capital gains on the money that was withdrawn will be taxed. Current law allows beneficiaries to enjoy tax-free growth in inherited Roth accounts with non-taxable distributions spread over their lifetime.
The Finance Committee’s proposal does offer some important exceptions to the five-year rule, however. These exceptions include the surviving spouse, charities and charitable remainder trusts, minors, disabled and chronically ill individuals and beneficiaries born within 10 years of the deceased IRA owner. However, the big news is that the proposal also contains an unexpected provision — the ability of the beneficiary or beneficiaries to exclude $450,000 (indexed for inflation) of inherited retirement assets per deceased IRA owner from the five-year rule. Note, $450,000 is the maximum exclusion amount regardless of the number of beneficiaries. The proposed exclusion creates enormous complications for planners, but also opportunities that your clients can use to their advantage.
How the Exclusion Will Work
If your client dies and leaves a $1.45 million IRA to his only child, the child can claim the exclusion and stretch and defer taxes on $450,000 over his lifetime consistent with existing law. He must, however, withdraw the remaining $1 million within five years, subjecting the larger portion of his inheritance to accelerated income taxes. The exclusion, like the entire law, applies to all retirement plans including IRAs, 401(K)s, 403(b)s, simplified employee pensions and qualified retirement annuities — both traditional and Roth accounts. Note, if your client has more than one IRA or retirement account, he can’t just apply the exclusion however he wants. His beneficiary will be permitted to stretch a prorated portion of each account, but within five years, he must withdraw and pay tax on whatever remains.
Example 1: Your client has $2 million in retirement assets consisting of a $1.2 million traditional IRA, a $500,000 401(K) and a $300,000 Roth IRA. Here’s how the calculation will look:
IRA (traditional) $1.2 million / $2 million = 60 percent
401(K) $500,000 / $2 million = 25 percent
Roth IRA $300,000 / $2 million = 15 percent
So when the beneficiary applies the above percentages to the $450,000 exclusion amount, he’ll be able to stretch $270,000 of the traditional IRA, ($450,000 x 60 percent), $112,500 of the 401(K) ($450,000 x 25 percent) and $67,500 ($450,000 x 15 percent) of the Roth IRA. The accelerated tax rules would apply to $930,000 of the traditional IRA and $387,500 of the 401(K). An amount of $232,500 of the Roth IRA would have to be distributed within five years, but wouldn’t be subject to tax.
Unexpected Planning Opportunities
Overlooking planning opportunities that are available because of the $450,000 exclusion could be costly to the heirs. Each IRA owner is entitled to exclude $450,000 from the accelerated tax rule, but an unused exclusion can’t be transferred to a surviving spouse. If your client simply leaves everything to his spouse, the family will lose the chance to exclude a portion of the account from accelerated tax. This knowledge should serve as a wake-up call to married clients who have a lot of money in retirement accounts. Whenever possible, it makes sense to take advantage of both exclusions — otherwise, your clients will lose the opportunity to take advantage of enormous tax savings.
Discussions With Your Clients
If the family’s combined IRA balance is less than $450,000 and isn’t likely to grow beyond $450,000, no special planning will be needed unless Congress decides to use a different exclusion amount. If the combined balance of the IRAs is greater than the exclusion amount, then strategic planning will be needed to protect your clients from a harsh new tax structure. One recommendation, as noted above, is to establish enormous flexibility in the estate-planning documents with extremely liberal disclaimers. I like provisions allowing the surviving spouse to disclaim to children and provisions allowing children to disclaim to trusts created for the benefit of their children.
In my experience, clients are more comfortable and confident when I forewarn them of potential legislative changes that I believe have a good chance of passing, and discuss with them what they can do now and after the law passes. They seem to appreciate frank and honest discussions about issues that could have an impact on their family’s financial security. And, isn’t it better that they learn about them from you, rather than from one of your competitors?
This is an adapted version of the author’s original article in the June issue of Trusts & Estates.
