We may soon see the end of a valuable estate planning tool known as the stretch IRA, which allows the tax deferred status of an inherited individual retirement account (IRA) for as long as possible when the beneficiary is someone other than a spouse. This tool is typical of the planning currently being done with younger beneficiaries such as children and grandchildren.
In September 2016, the Senate Finance Committee voted 26-0 to eliminate the stretch IRA. This bipartisan recommendation was included as part of the proposed Retirement Enhancement and Savings Act of 2016 (RESA). In the past, a unanimous vote by the Committee would make passage by Congress a near certainty. While future tax law may be difficult to predict under the current administration, it is clear that the intention is to cut taxes while needing to find sources to raise revenue to support the tax cuts. This proposed law already enjoys strong bipartisan support from the members of the Finance Committee and would provide an easy source of a significant amount of revenue. If Congress accepts the proposal, the estate-planning strategies recommended for large IRAs will change forever.
With some exceptions, the Finance Committee’s proposal requires beneficiaries of inherited IRAs to withdraw and pay income tax on the entire IRA within five years of the IRA owner’s death. This accelerates income taxes and will likely push the beneficiary into a higher tax bracket during the distribution years. All retirement accounts have been targeted, even Roth IRAs. Roth accounts won’t be subject to income tax but, like the other qualified plans, will have to be distributed within five years of the Roth IRA owner’s death. Though the distributions from Roth accounts are not taxable, all further interest, dividends and capital gains on the money that was withdrawn will be taxed.
There are some exceptions to the 5-year rule under the Finance Committee’s proposal. The exceptions include the surviving spouse, charities and charitable remainder trusts, minors, and disabled and chronically ill beneficiaries born within 10 years of the deceased IRA owner. If the beneficiary is a minor, the 5-year tax acceleration clock starts ticking when they reach the age of majority. When a beneficiary who is stretching an inherited IRA dies, their heirs will be subject to the 5-year rule immediately.
The Finance Committee’s proposal 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 5-year rule. Note that $450,000 is the maximum exclusion amount regardless of the number of beneficiaries.
This $450,000 exclusion allows for some planning opportunities. Each IRA owner is entitled to exclude $450,000 from the accelerated tax rule, but an unused exclusion cannot be transferred to a surviving spouse. If a couple’s combined IRA balance is greater than $450,000, then strategic planning will be necessary to reduce the impact of the harsh new tax structure. Contact your CPA and/or estate planning attorney to discuss estate planning options available to help reduce the impact of this proposal, should it be implemented.
Pamela Wheeler, EA