Proposed Changes to Inherited IRA Stretch Rules

Written by: Eldridge Blanton

Posted on: June 28, 2019

inherited IRA stretch rules

Article written by M. Eldridge Blanton, III, Esq. and Jeremy L. Pryor, Esq.

On May 23, the U.S. House of Representatives passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act.  If its counterpart in the Senate is also adopted and the President signs it, the SECURE Act will become law.  The changes made by the SECURE Act are wide-ranging —including provisions to increase the minimum age for taking required minimum distributions (RMDs) from retirement accounts from 70½   to 72, and allowing persons over the age of 70½ to continue to contribute to their individual retirement accounts.   But the major change, and the one we will focus on in this newsletter, is the replacement of the rule that allows persons who inherit a tax deferred retirement account (which includes IRAs, 401(k)s, 403(b)s, 457s, and TSPs) to stretch out their RMDs over their lifetimes, to a stretch out of no more than ten years.

Currently when someone inherits a tax deferred retirement account (other than a Roth IRA or Roth 401(k)), that individual can either (1) take all of the funds out of the account and pay all of the taxes at one time or (2) take required minimum distributions annually and pay the taxes on the RMDs.  The second option is informally known as stretching the retirement account, and from a tax planning perspective it is often the most efficient option.  Here’s an example of how the current rule works. 

Assume Johnny inherits his father’s IRA when his dad dies, and the IRA has a value of $100,000 at the time of his dad’s death.  If Johnny chooses to take the $100K out of the IRA upon inheriting it, he will have $100,000 of additional income in the year he takes the money out and will pay income taxes on that extra $100K at his personal tax rate (which will be determined by adding the $100K to any other sources of income he has that year).  Johnny can now invest that $100K however he would like and will pay income taxes on any future income generated by the $100K, also at his personal rate. 

Now assume that Johnny inherits his dad’s $100K IRA and instead of taking all of the money out of the IRA, he elects to keep money in the IRA and treat the IRA as an inherited IRA.  In this case, the custodian of the IRA (typically an investment firm) will require that Johnny provide it with his date of birth, and will calculate required minimum distributions that Johnny must take out of his inherited IRA each year based on his life expectancy.  If Johnny is 50 years old when his dad passes away, Johnny’s RMD the first year will be relatively small (approximately $3,000), and Johnny will only need to pay income taxes on the $3,000  that he takes that first year.  The remaining balance of $97K will continue to be invested and grow tax- deferred.  With the magic of compound interest and tax-deferred reinvestment of earnings, the value of the inherited IRA will ultimately be much greater than the initial $100K Johnny inherited.

If the SECURE act passes, Johnny will lose the option to take RMDs over his life expectancy and instead he will be required to withdraw all $100K of the IRA he inherits from his dad within ten years.  The total financial benefit for Johnny will steeply decline as a result.  So where does that leave us as estate planners?  The short answer: it depends.

Under current law, and also under the SECURE provisions, spouses can leave their IRAs to each other.  Upon the death of the first spouse, the “surviving” spouse will usually choose to exercise a “spousal rollover,” which in effect makes the surviving spouse the IRA owner.  In a first marriage, the spousal rollover presents few problems.  If for one (or both) spouses, the marriage is a second one, there may be issues concerning the persons to receive the IRA funds after the SECOND death. 

Assume that our client wants to maximize the substantial benefit of stretching a retirement account via the spousal rollover but also wants to make sure that her surviving husband doesn’t leave the retirement account to anyone other than HER children when he dies.  With a situation like that, she can’t achieve both objectives and must think long and hard about whether the benefit of maximizing the stretch is more important than the goal of getting the retirement account to the right ultimate beneficiaries.

Our client may have other concerns. Suppose she wants to leave the retirement account to a child with substance abuse or creditor problems.  Will it be better to leave the retirement account to a trust for the benefit of the child with a mandatory distribution standard and conduit-style provisions or use a discretionary distribution standard with accumulation-style provisions for that child?  Here she must weigh the significance of the substance abuse or creditor concerns of the child against the tax consequences of holding taxable income in a trust that has a 37% marginal income tax rate on every dollar of income received from the inherited IRA exceeding $12,750.  This is not an easy decision under any circumstances.

For clients with significant wealth saved in retirement accounts, the SECURE Act would make the prospects for using an IRA as a vehicle for delivering a large inheritance much less appealing. Therefore we expect that our job will become focused more on strategies for reducing the income tax bite of liquidating retirement accounts while our clients are alive.

Regardless of what happens with the SECURE Act, we’ll be prepared to advise you about how best to proceed with your retirement and estate plans.

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