While not its own type of IRA, a stretch IRA had been a go-to strategy for estate planning that allowed non-spousal beneficiaries to extend inherited IRA distributions over a long period of time, potentially ‘stretching’ those withdrawals out over several future generations.
During this time, the IRA continued to grow tax-deferred, and this growth time could wind out so long because beneficiaries could take required minimum distributions (RMDs) based on their own ages.
This option ended when the SECURE Act went into effect in December of 2019; the new regulation mandated that any IRAs inherited after the end of 2019 must be emptied within a ten-year period. While stretch IRAs that already existed may operate under the previous rules, as can those for spouses and disabled beneficiaries, for account owners who had planned to use stretch IRAs for their own estate planning, the new rules presented a problem…potentially a big tax problem for their heirs.
Consider, for example, a $10 million IRA that converts to a stretch IRA for a beneficiary under the new policy. The beneficiary could choose to withdraw $1 million annually over the next ten years or withdraw the entire amount in a lump sum; either way, the account must be exhausted within ten years.
Withdrawals could create huge tax liabilities for large IRA accounts, meaning it may be advantageous for high-net-worth investors such as physicians or business owners to consider alternatives to the stretch IRA as an estate planning strategy.
Charitable Remainder Trust
In a Charitable Remainder Trust, the donor places assets into the trust and continues to receive income from them through their lifetime; upon their death, the assets pass to the designated charity.
Depending on the type of trust, these distributions may payout as a fixed annuity or as a percentage payment, and the trust may or may not allow additional contributions. An IRA owner can name a Charitable Remainder Trust as a beneficiary, giving the beneficiaries of the trust itself a lifetime stretch and the named charity receiving the remaining balance. One downside? The assets are not easy to access all at once, should the need for them arise.
Fund yourself with life insurance
Since tax liability stemming from the potential large stretch IRA withdrawals over the decade-long emptying period is the main concern, it may be helpful to cover those taxes for beneficiaries with life insurance payouts. Survivorship life insurance, also known as second to die life insurance or dual life insurance, insures two people, often spouses, with a single policy, making it more cost-effective.
The benefits payout after the death of the last surviving insured, and therefore shelter heirs from a heavy tax burden. If the assets are large enough, another strategy could be to have a life insurance trust own the insurance, thereby keeping it out of the estate.
Life insurance can be helpful for both account owners and their beneficiaries. Individuals who do not need their RMD amounts can use these funds to purchase life insurance to benefit their children; in this way, a policy could even grow larger than the original IRA, passing on more of a legacy to beneficiaries than the IRA on its own would have.
More Roth IRA conversions
Like IRA accounts, Roth IRAs are also bound by the 10-year rule, but the distributions are tax-free. Traditional IRAs, which are funded with pre-tax monies, can be converted to Roth IRAs, which are funded by already-taxed dollars. By converting IRA accounts to Roth IRAs when the market is down or there is an otherwise favorable tax environment, an account owner will have already covered taxes when the Roth IRA is left to beneficiaries and can let it grow tax-free.
If an individual has a large amount of pre-tax funds, 401(k) Roth IRAs and backdoor Roth IRAs may also be viable options. In a backdoor ROTH IRA, you can contribute funds in a traditional IRA and transfer the funds’ immobility to a ROTH IRA. Since the funds are post-tax, there is no tax on the principle. When considering Roth IRA strategies, they are often a better option for heirs whose tax bracket will be at least as high as the original account owner’s.
More retiree spending from IRAs
Traditional wisdom holds that retirees should spend from their Roth IRA accounts first, then taxable accounts, then finally moving on to IRAs as those accounts are taxable. However, another strategy for retirees who don’t need the immediate income from IRA RMDs is to use those required withdrawals as qualified charitable distributions (QCD), spending more from retirement expenses while leaving the Roth IRAs and personal accounts as inheritance assets for their heirs.
A QCD is a direct transfer from an IRA custodian payable to a charity that counts toward RMD. This allows the account owner to donate to their charity of choice while also removing that amount from taxable income and their estate. As the account owner is likely in a lower tax bracket than inheritors would be in the future when they took withdrawals, this strategy leaves the tax-free withdrawal options open for beneficiaries from other Non-IRAs accounts to help them avoid hefty tax bills.
Of course, these are only some of the strategies that could replace the stretch IRA as an estate planning tool. Every individual’s situation is unique—the best solution may be one of those mentioned above, a combination of several of these ideas, or something else altogether.
Because of the new laws and the potential complications they can cause for those involved in planning their legacies, it is best to meet with a fiduciary financial advisor working with a team of in-house experts, such as attorneys and CPAs. To get the best advice and guidance, prioritize working with a team that can coordinate and create a customized solution for your financial future.