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The Death of the “Stretch” IRA

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The Death of the “Stretch” IRA

A distressing element of the 2019 SECURE Act (Setting Every Community Up for Retirement Enhancement Act, part of the Further Consolidated Appropriations Act, 2020 (P.L. 116-94, H.R. 1865)), the late 2019 spending measure to fund the government, is a provision that will create the need for dramatic changes to estate planning.  Many middle-class and upper middle-class families have adopted a long-term plan to defer and minimize income taxes on qualified retirement funds (Individual Retirement Accounts or IRAs) as long as they could.  Typically, the qualified retirement fund is the largest asset in the estate of a middle-class family, built up over the lifetime of a working taxpayer.  Many employers and their employees invest for retirement in a tax “qualified” retirement account, an IRC 401(k) plan, IRC 403(b) plan or other similar pension fund. At retirement, many employees remove the fund from the employer’s plan and place it, for continued investment, in the employee’s IRA.  This new law will eliminate a common part of the estate plan and will require attention by many clients.

Prior to the 2019 SECURE Act, a taxpayer had been permitted to defer payments on their retirement account until reaching the age of “70 ½,” at which point certain amounts needed to be withdrawn from the retirement fund, known as the “Required Minimum Distribution” rules (RMD).  One sidelight of the new law allows the “start date” for RMDs to be pushed back to age 72 instead of the age of 70 1/2.  By being forced to begin distributions at (now age) 72, the income tax deferral ends and some amount of the fund becomes subject to income tax.   Under the RMD rules, a taxpayer is required to withdraw the funds over the actuarial life expectancy of the taxpayer and a hypothetical “spouse” that was arbitrarily determined to be 10 years younger than the taxpayer.  Each year, the tables mandate a small sum be distributed to the taxpayer, hence, ending the deferral achieved through the creation of a retirement account.

For estate planning purposes, and in order to achieve additional income tax deferral, many clients chose to name their spouse as the primary beneficiary because a spouse is permitted to “rollover” any balance in a fund.  If a spouse “rolls over” the balance in the fund, it is treated as his/her own account for purposes of the RMD rules and hence, additional deferral continues. However, only a surviving spouse can “rollover” an IRA so that at the passing of the surviving spouse, a new rule applies.  Under IRC Section 401(a)(9) for traditional income tax planning, upon the death of the surviving spouse (or surviving parent) non-spousal beneficiaries, such as children, are allowed to treat the fund (or their ratable share) as an “Inherited IRA” and pre-2019 law allowed a generous mechanism for continuing income tax deferral.

Under the law for pre-2019 decedents, a non-spousal beneficiary could withdraw funds from the retirement account over their life expectancy set at the date of death of the decedent.  For example, if a beneficiary of a retirement account was age 62 at the death of the surviving parent, the IRS tables provided for about a 23-year term life expectancy.  Thus, the Inherited IRA needed to be withdrawn from the fund over that 23-year term by using the remaining term as a denominator; e.g, 1/23rd the first year, 1/22nd in the second year, 1/21st in the third year and so on.  Of course, a beneficiary could withdraw greater amounts sooner, but any amount taken from an Inherited IRA would be subject to income tax. Thus, if there were other resources available to the IRA beneficiary, he or she may choose to rely on the other non-taxable resources before taking from the Inherited IRA.  The longer the “pre-tax” money stays in the retirement account, the more it will have an opportunity to grow for the overall benefit of the family.  While a 62-year-old designated beneficiary had to withdraw his or her share of the fund over a 23 year term, a 50-year-old beneficiary had about 34 years, and a 30-year-old beneficiary had 53 years. This planning approach has become known as the “stretch” IRA plan and it has become a significant element of planning for well to do taxpayers with substantial amounts saved in the IRA.

The 2019 SECURE Act has made a radical change to this part of the law.  Now, post 2019, the law will generally mandate that distributions must be taken from an Inherited IRA within 10 years of death of the plan owner (the “plan owner” could be the participant or the spouse, after rollover).  Under the new law, no required minimum distribution amount is required in any particular year as long as all of the funds are withdrawn by December 31st of the year that contains the 10th anniversary of the decedent’s passingIt is possible that some clients will be confronted with this change in the law and will make no changes. However, advisors should be advised to review these rules so that clients can adopt the plan that is most suitable for their situation.

Under the pre-2019 law, the statute defined “Designated Beneficiary” (“DB”) as an individual, and a DB could remove the funds over his/her life expectancy, as explained above. If a beneficiary was not a DB, as defined in the law, such as the decedent’s “estate,” generally the funds needed to be subject to tax over a 5-year period. A DB will now be subject to the 10-year distribution term and not the life expectancy rule. However, under the new law, a limited exception to the 10-year rule is created through a new category of beneficiary known as an “Eligible Designated Beneficiary” (or “EDB”). There are five EDBs who are not subject to the new rule: i) a spouse, ii) a minor child, iii) a disabled beneficiary[1], iv) a chronically ill individual[2] and v) a beneficiary that is within ten years of age of the decedent.  Thus, for example, a minor child need not take distributions until after reaching majority; however, at legal majority the beneficiary would have 10 years to take out the balance of the fund. Since the provision refers to a “child,” it would not apply to a step-child, grandchild (or other younger heir).

Because the exceptions are few and far between, this new rule will change planning for many clients.   For some clients, no change will be necessary at all.  Depending on the size of the fund (IRA) and number of children, naming the children as beneficiary at the death of the surviving spouse may be appropriate.   If the amount is not too much, the funds may have been withdrawn and spent in a short term anyway.  Unfortunately, because of the new rule, much of the fund may be depleted while the child/beneficiary is in his or her high earning working years and, thus, would be taxed at a higher marginal rate bracket.  For example, under old law, if a fund was “stretched” to a beneficiary into their early 80s, most of the funds could be taken in the beneficiary’s 70s, while the child/beneficiary had already entered retirement years and thus,  would possibly be in a lower marginal bracket.  By contrast, if the funds are to be taken out in shorter order, a child/beneficiary may be in their 40s or 50s and, presumably, in a higher marginal income tax rate.  Since the retirement fund is added on top of other earnings, it surely will be subject to more income tax than under prior circumstances.

One planning strategy may involve possible reallocation of the funds at the death of the predeceasing parent rather than accumulating all deferral until the death of the surviving spouse.  If the surviving parent will not need the entire retirement fund from the deceased parent’s IRA, there may be a benefit to dividing the IRA among a multitude of beneficiaries.  It should be noted that the special rule for distribution to “minors” (as an EDB) would apply to a decedent’s children only, and not to grandchildren or other minors.  Moreover, some minors may be subject to the unearned income tax on minors (historically referred to as the “kiddie” tax), thus, a minor may be in the higher marginal bracket.

Some clients may choose to reconsider their retirement planning structure at the outset by converting retirement funds into “Roth” retirement funds.  With a “Roth” retirement fund, no income is imposed upon the distributions or growth on distributions, but no tax benefit is afforded upon the initial contribution into a Roth retirement fund.  The traditional “RMD” rules do not apply to a Roth IRA for a plan participant, but the RMD rules, and now the new 10-year distribution requirement, will apply to a Roth IRA fund.  Under this planning theory, no income tax deferral is permitted, but at least the beneficiary avoids the bunching of marginal bracket upon eventual distribution from the fund.

Another possible technique for charitably inclined clients willing to accept some complexity is the testamentary creation of a Charitable Remainder Trust.  A Charitable Remainder Trust can be structured either with a fixed annuity (Charitable Remainder Annuity Trust -CRAT) to a beneficiary or, alternatively, a percentage of the fund balance each year, called a “unitrust” (Charitable Remainder Unitrust- CRUT).  The CRAT or CRUT can be structured for a set term no more than 20 years or, for the life of a beneficiary or beneficiaries.  A taxpayer can designate the CRAT or CRUT as beneficiary and at death, upon receipt of the entire fund by the trustee of the Charitable Remainder Trust, there would be no immediate income tax imposed.

With this plan, immediate income tax is avoided but there are many disadvantages. Most importantly, for our New Jersey clients, is that New Jersey does not respect the tax free nature of a Charitable Remainder Trust. Thus, the entire amount would be subject to New Jersey income tax upon receipt in the CRT.  Perhaps the trust could be set up with a non-resident (of New Jersey) trustee as a means of eliminating some New Jersey tax, but nevertheless, even that approach would increase complexity.  While some may be interested in this approach as an alternative means of achieving longer term deferral in a trust, caution is needed to avoid unexpected consequences.

Under the pre-2019 law, a taxpayer that wanted (or needed) to have the monies in the IRA controlled by a Trustee could use a “conduit” trust, a mechanism to both provide the benefit of a trust and also, receive the long term payout of the “stretch” IRA plan.  A conduit trust was permitted to be a DB (and thus, allowed the extended life expectancy payout), if the required distribution from the IRA was required to be paid to the trust and then immediately to the trust beneficiary.  In other words, the rules allowed the long term “stretch” payout over the life of the trust beneficiary by looking through the trust to the beneficiary.  In some cases, parents designated a trust as beneficiary of the Inherited IRA, perhaps because of concern for how the beneficiary would spend the IRA if payable directly to him or her.

Under the new law, those conduit trusts would require the RMD to be withdrawn and paid out to the beneficiary within ten years. The non-tax goal (e.g., concern with the beneficiary’s spending) will be thwarted by the changes to the law. Under the new rules, if the trust is not revised, the entire balance of the IRA would be distributed to the beneficiary in 10 years.  Thus, clients that have adopted a “conduit trust” (or so called “Trusteed IRAs”) as part of their planning, should determine whether changes are needed to accomplish their non-tax goals of allowing a trustee to manage money. If the IRA balance is to be held in the trust (rather than distributed to the beneficiary), attention should be called to the fact that a trust is in the highest marginal income tax bracket when the income threshold meets only about $13,000 of income.

In sum, the death of the “stretch IRA” planning option will require revisiting of plans for many Kulzer & DiPadova clients.  Perhaps the effect of a discussion will be that there are no alternatives that a client would want to undertake. It could (likely) mean merely that there is an obligation for higher taxation on the retirement fund balance after the passing of the loved one.  Nevertheless, clients should be advised that there are issues that they may seek to reconsider as a result of this new Act.

[1]           See IRC 72(m)(7).

[2]           See IRC 7702B(c)(2).

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