A newly minted federal law makes it easier for millions of Americans to save for retirement.
But hidden inside the legislation is a bomb that could explode the well-laid plans of retirees hoping to leave an inheritance for children or other loved ones.
As we have reported, the Setting Every Community Up for Retirement Enhancement (SECURE) Act will help more people save for retirement for a longer period than ever before.
However, the SECURE Act includes a dark cloud — the elimination of the so-called “stretch IRA” — that has “sent financial planners and tax professionals scrambling,” according to a report from Morningstar, a global financial services firm.
Previously, retirees with large nest eggs could pass down an IRA or another retirement account to children or others secure in the knowledge that these heirs could slowly make withdrawals from the accounts over the course of a lifetime.
Withdrawing money from such accounts gradually over decades offered a potentially life-changing financial advantage for heirs: the ability to allow the money to compound for years, possibly even many decades, in a tax-sheltered account.
To illustrate the advantage of this strategy, Leon LaBrecque — chief growth officer of Sequoia Financial Group — imagines in a Forbes piece that a wealthy grandfather leaves a $1 million IRA to his 25-year-old granddaughter.
Under the old rules, the granddaughter could spread out the distributions over the remainder of a projected 57.2-year lifetime. Her first-year distribution would be $17,482 (an amount that is calculated based on the account balance and her life expectancy).
Depending on the granddaughter’s income at the time of that first withdrawal, she would owe between $548 and $6,468 in taxes on that money.
Meanwhile, the remainder of her money would be allowed to grow in a tax-sheltered account.
At a relatively modest growth rate of 7%, the lucky granddaughter would have about $1.75 million after a decade. And that money — minus annual withdrawals — would continue to compound for decades to come.
The SECURE Act derails the gravy train
But all that has changed. The SECURE Act basically ended the stretch IRA. Instead, most beneficiaries — with some important exceptions — will be required to withdraw every last dime of their IRA inheritance within a 10-year window.
LaBrecque says the impact could be seismic. That formerly lucky granddaughter will now need to withdraw her $1 million much more quickly, which will increase her income, thus pushing her into a higher tax bracket and increasing her tax rate.
LaBrecque estimates that those forced withdrawals will raise the hypothetical granddaughter’s total tax bill on her inheritance $300,000 to $400,000 higher than it would have been under the old rules.
And collecting such huge amounts of tax dollars is likely the reason Congress ended the “stretch IRA.” Estimates suggest the government will rake in about $15 billion over a decade thanks to the change.
Morningstar notes that the new law could have other negative impacts, such as forcing older heirs who suddenly find themselves in a higher tax bracket to pay taxes on Social Security benefits, or reducing the likelihood that some heirs will qualify for college aid programs when their children enter school.
It’s important to note that the new law carves out some exceptions that will allow the “stretch IRA” to live on for some folks.
For starters, the law only applies to deaths after Dec. 31, 2019. If you have been enjoying the benefits of the stretch IRA that you inherited from someone who died before then, you can continue to enjoy those benefits.
Also, IRA analyst Sarah Brenner highlights some other important exceptions to the new rule. Writing at the Ed Slott and Co. website, she says:
“There are five classes of ‘eligible designated beneficiaries’ who are exempt from the 10-year post-death payout rule and can still stretch RMDs over life expectancy. These include surviving spouses, minor children (but not grandchildren), disabled individuals, the chronically ill, and beneficiaries not more than ten years younger than the IRA owner.”
What you can do now
The sudden elimination of the stretch IRA means retirees may need to rethink their estate plans.
At the least, retirees should review the beneficiaries on their retirement accounts and perhaps also discuss with those loved ones what the end of the “stretch IRA” means for their inheritance.
LaBrecque points out that the new law applies to all qualified retirement plans, which includes 401(k) accounts. So, the change will have a wide-ranging impact.
Both LaBrecque and Slott say the end of the stretch IRA enhances the attractiveness of Roth IRAs in estate planning, as money in Roth accounts grows tax-free and can be withdrawn tax-free. As Slott tells Morningstar:
“The law simply says you must take out the money after 10 years. Your heirs could simply leave the Roth alone for 10 years and let the assets grow tax-free — and then take a lump sum. All that growth is tax-free, and it comes out tax-free.”
Estate-planning decisions must be tailored to the individual making them. So, it’s best to sit with a qualified financial adviser and discuss your options before overhauling your estate-planning strategy.
But perhaps the most important lesson from the end of the stretch IRA is the timeless truth it reinforces: Stay on your toes and remain flexible when planning your finances, because nothing lasts forever.