Stretch IRA Rules

What are the Stretch IRA Rules? The SECURE Act changed the Stretch IRA rules as of January 1, 2020. While this was a proposal, I wrote 7 Strategies If The Stretch IRA Is Eliminated, which continues to get read numerous times every month. Today, we are going to dive into the new rules for IRA Beneficiaries. This is important because if you are leaving a large retirement account to your heirs, there could be a large tax bill! And if you don’t know these rules, you could make it even worse.

First, old Stretch IRAs are unchanged and are grandfathered under the old rules. So, for anyone who passed away by December 31, 2019, their beneficiaries could still inherit the account into a Stretch IRA. That means that they only have to take Required Minimum Distributions each year. They can leave the money invested in a tax-deferred account. For many of my clients with inherited IRAs, their Stretch IRAs have grown even though they are taking annual withdrawals!

Under the new rules, there are three classes of IRA Beneficiaries. First, there are Eligible Designated Beneficiaries (EDBs) who will still be able to use the Stretch IRA Rules. Second, there are non-Eligible Designated Beneficiaries (non-EDBs), who are now going to have to withdraw all the money within 10 years. This is called the “10 Year Rule”. Third, there could be a Non-Designated Beneficiary.

Eligible Designated Beneficiaries

There are six situations where an IRA Beneficiary today could use the old Stretch IRA rules.

A Spouse
Minor Children (see below)
Disabled Persons
Chronically Ill Individuals
Persons Not more than 10 years younger than the IRA owner
Certain See-Through Trusts

These individuals could inherit an IRA and use the old Stretch IRA rules. For example, if you left money to your sister who is 8 years younger than you, she could do a Stretch. Or to a friend who was disabled. The old rules and benefits will still apply in these cases!

Spouses and Children

Minor Children are not given an unlimited Stretch IRA, unlike in the past. Today, Minor Children can stretch the IRA until the age of majority, 18 or 21, depending on the state. If they are a full-time college student they can stretch until age 26. When they reach that age, then the 10 Year Rule kicks in and they must withdraw the remainder of the IRA within 10 years.

Spousal beneficiaries have a choice in how they treat the inherited IRA. They can roll it into their own IRA and treat it as their own. This is helpful if they are younger than the decedent and want to have smaller RMDs. However, if they are younger than 59 1/2, they might prefer to put it into a Stretch IRA. That way they can take withdrawals now and avoid the 10% pre-mature distribution penalty. If a surviving spouse is older than the decedent, they could use the Stretch IRA so they can put off RMDs until the decedent would have been 72.

Non-Eligible Designated Beneficiaries

Any person who is not one of the six EDBs is a non-Eligible Designated Beneficiary. Non-EDBs are must withdraw their entire IRA within 10 years. This would include adult children, grandchildren, or any other relative or friend who is more than 10 years younger than the IRA owner. Most non-spouse beneficiaries will be non-EDBs.

The IRS created some confusion this year as to what the 10 Year Rule Means. One document suggested that beneficiaries would still be required to take out some of the inherited IRA annually. That turns out not to be the case, as the IRS clarified in publication 590-B, Distributions from IRAs. Under the 10 year rule, there is no RMD or annual requirement. Beneficiaries have complete choice in when they withdraw from the IRA. The only requirement is that the whole account is withdrawn in 10 years.

For most beneficiaries, you will still want to draw down a large account gradually. Taking small withdrawals each year is likely to result in lower taxes than if you wait until the 10th year. For example, it would be better to take $100,000 a year for 10 years than $1 million all at once. This does give us some room for customization. If you have a low earning year, that could be a better year to take out a larger amount. If your tax rate will go up in 2022 or 2026, you might want to accelerate withdrawals while under a lower rate.

Non-Designated Beneficiaries

The third category is Non-Designated Beneficiaries. An NDB could occur if you don’t name a beneficiary, if you name your Estate as the beneficiary, or a charity or certain trusts. NDBs have the worst outcome, the old 5-year Rule. NDBs must withdraw the entire IRA within 5 years. Many people who established Trusts prior to 2020 named their trusts as the beneficiary of their retirement accounts. This will backfire now because the Trust cannot Stretch the distributions. And with Trust tax rates higher than for individual beneficiaries, this could hurt your beneficiaries quite a bit. If you have a Trust from before 2020, it should be revisited.

It is important that we review your beneficiaries from time to time to make sure they are up to date. It is also a good idea to have contingent beneficiaries in case your primary beneficiary pre-deceases you. IRAs do not have to go through probate. But if there are no beneficiaries, then this money could be tied up from months to more than a year as the Probate Court decides how to distribute your money.

Roth IRA Stretch Rules

Roth IRAs are inherited tax-free. So, on day one, any beneficiary can withdraw the entire Roth IRA balance and owe zero taxes. However, there are some options available for Roth Beneficiaries, too. And these also changed under the SECURE Act.

First, for spouses. A spousal beneficiary of a Roth IRA could take a lump sum distribution. Or they could roll the inherited Roth into their own Roth. Third, they could roll the Roth into an Inherited Roth account. In an Inherited Roth, they have two options for distributions. They can take annual Required Minimum Distributions based on their own age. Or, they can use the 5-year rule and withdraw the entire amount in 5 years. For most spouses, rolling the inherited Roth into their own will be a good course of action.

Non spouse beneficiaries also have an option to continue tax-free growth of a Roth. For Roth owners who passed away before 2020, beneficiaries could have elected to take RMDs. Under the new rules (owners who passed away after January 1, 2020), Roth Beneficiaries can use the 10 year rule. They have up to 10 years to take money out of their inherited Roth IRA.

Other Considerations

An inherited IRA also has a beneficiary. What happens then? Let say Mom left her IRA to her son years ago. Son has a Stretch IRA. Son passes away and leaves the inherited IRA to his wife. What now? You don’t get to Stretch twice. So the wife, in this case, is going to be under the 10-Year Rule. This is called a Successor Beneficiary.

A second example: Mom passes away in 2020 and leaves her IRA to her son. Son is under the 10-Year Rule. Son passes away in 2025 and names his wife as Successor Beneficiary. Does she get to restart the 10-Year Rule? No, the old rule applies, and she must withdraw the full account by 2030.

If you have a Beneficiary IRA, and are over age 70 1/2, you can also do Qualified Charitable Distributions. Most people don’t realize that QCDs could count towards their RMDs from an inherited IRA, too.

While I often only have one or two clients who inherit an IRA each year, every IRA owner should understand what will happen when they pass away. That’s why I am writing this somewhat technical article on the new Stretch IRA rules. By planning ahead, we can determine the best course of action for your situation. It could involve leaving a your IRA to charity, to a spouse, to children, grandchildren, or a trust. It may make sense to convert your IRA to a Roth.

For many of my clients, their largest accounts are IRAs. And there is a significant tax liability attached to those IRAs, for the owners, spouses, and heirs. If we plan well, we can help reduce those taxes!

Strategies if the Step-Up in Basis is Eliminated

Posted On March 31, 2021 By Scott Stratton, CFP(R), CFA In Tax Strategies / 1

Today, we look at strategies if the step-up is basis in eliminated for estate planning. There were two new proposals in the Senate this week which will target inherited wealth. These two Acts, if passed, would completely change Estate Planning for many families. The two Acts are called the STEP Act and the 99.5% Act.

The STEP Act

The STEP Act (Sensible Taxation and Equity Promotion Act), proposed by Senators Booker, Sanders, Warren, Whitehouse, and Van Hook would eliminate the Step-Up in Cost Basis. A Step-Up in Basis means that upon Death, an asset has its cost basis reset to the date of death. This allows the heirs to immediately sell an asset and receive the funds without owing any taxes. Or, if they choose to hold on to the asset, they will only owe tax on the capital gains from the date of death forward. Otherwise, they would owe taxes based on their parent’s cost basis (or other decedent).

The STEP Act proposes to eliminate the Step Up in Basis, retroactively to January 1, 2021. In its place, the Act would allow a one-time exclusion of up to $1 million of inherited capital gains. It also allows the tax to be paid over 15 years if it is an illiquid asset like a farm or business. Many older parents have held on to assets, such as mutual funds or real estate, specifically to get a step-up in basis for their children. Allowing for the exclusion of $1 million in capital gains at death will help most families. But include real estate, and many families will have over $1 million in unrealized capital gains. And those families will now be paying a capital gains tax.

The 99.5% Act

The 99.5% Act, proposed by Senator Sanders, will increase the Estate Tax paid by many families. Currently, the Estate Tax Exemption is $11.7 million ($23.4 million for a couple), which has effectively eliminated the Estate Tax for Middle Class Families. Previously, the Estate Tax Exemption was $1 million, as recently as 2003. My clients have welcomed the increase of the Estate Tax Exclusion over the past 17 years. The 99.5% Act includes provisions to:

Reduce the Estate Exemption from $11.7 million to $3.5 million.
Reduce the Unified Gift Exemption from $11.7 million to $1 million per lifetime.
Raise the Estate Tax Rate to a range of 45-65%.
Reduce the Annual Gift Tax Exclusion from $15,000 to $10,000 per donee, AND impose an annual limit of $20,000 per donor.
Reduce certain tax benefits of Trusts, Generation Skipping Trusts, etc.

While I don’t cater to the ultra-wealthy, I do have a number of Middle Class families who this will impact. Ideas in Washington often stick around until they become reality. So, if these Acts don’t get passed now, don’t think that we will never hear them again. I don’t think there will be much empathy for families who have over $1 million in unrealized capital gains. However, in some cases, children will need to sell the houses, farms, and businesses they inherit to pay for these new taxes.

How Many Taxes?

Just to be clear, the Estate Tax is in addition to any Income Tax or Capital Gains Tax. Under the two proposals, an individual who dies with $5 million, would owe a 45% Estate tax on $1.5 million (the amount above $3.5 million). That’s a $675,000 Estate Tax Bill. Then, if their cost basis was $1 million and the unrealized capital gain was $4 million, the heirs would owe another 23.8% on $3 million of capital gains. That would be another $714,000 in taxes, for a total of $1,389,000. Presently, that tax would be zero, so we are talking about a huge increase. Let’s consider eight strategies if the step-up in basis is eliminated and other changes enacted.

Ways to Reduce Taxes under STEP and 99.5% Acts

1. If the Step-Up in Basis is eliminated, you may want to pay your capital gains gradually. Aim to keep your total unrealized gains under $1 million. For example, if you have $2 million in gains, perhaps you could harvest $100,000 of gains for the next 10 years. The goal is for you to pay the gains gradually at the 15% rate and save your heirs from being taxed at the 23.8% rate.

There is a separate proposal from Biden to increase the long-term capital gains rate for taxpayers in the highest tax bracket to 39.6%. Plus you would be subject to the 3.8% Medicare Surtax and state income taxes. And then, capital gains will be taxed at 43.4% to well over 50% in many states. The government would take more than half of your gains! If that happens, it will be vitally important to harvest gains regularly to avoid pushing your heirs into the top bracket.

Roth IRAs

2. Keep your high growth investments in a Roth IRA. Beneficiaries inherit a Roth IRA income tax-free. The Roth 401(k) looks better every year, versus a tax-deferred Traditional 401(k). If higher taxes are ahead, it may be preferable to use the Roth 401(k).

3. Gradually convert your Traditional IRAs to a Roth. By pre-paying the taxes today, you can both shrink the size of your taxable estate and reduce the Income tax burden on your heirs. The current tax rates will expire after 2025. The next five years is a good window to make Roth conversions.

Plan Your Giving

4. Give away your full Annual Gift Tax Exclusion every year. Reduce your Estate. Please note that the direct payment of someone’s medical or education bills does not count towards the annual exclusion. Do not reimburse your children for those expenses – make the payment directly to the doctor, college, etc.

5. If you make charitable donations, give away your most highly appreciated securities, rather than cash. This will reduce your taxable gains. If you do want to leave money to charity, make a charity a beneficiary of your Traditional IRA. If you are over age 70 1/2, you can make charitable donations of up to $100,000 a year from your IRA as Qualified Charitable Donations, or QCDs. QCDs can reduce your taxes so you have more budget to harvest capital gains from taxable accounts. You do not have to itemize to deduct QCDs.

Other Estate Tax Savings

6. Sell your primary residence. A couple, while alive, can exclude $500,000 in capital gains on the sale of their primary residence, as long as they lived there at least 2 of the past 5 years. ($250,000 for single filers.) Let your kids inherit the house and that capital gains exclusion may be lost. Better to sell it yourself and buy another house where you don’t have the big capital gains.

7. Maximize your contributions to 529 College Savings Plans for your children or grandchildren. These will pass outside of your taxable estate and will grow tax-free for the beneficiaries. 529 Plans will not be taxable under any of these proposals, and will become a more important estate planning tool.

8. Life Insurance proceeds are not subject to income tax to the beneficiary. Additionally, If we establish your insurance policy with an Irrevocable Life Insurance Trust (ILIT) as the owner, the life insurance will pass outside of your Estate and not be subject to the Estate Tax. This didn’t matter as much when the Estate Exemption was $11.7 million. ILITs will benefit a lot more families if the Estate Exemption is reduced to $3.5 million. Include the tax benefits, and Permanent Life Insurance looks even better as an asset.

Higher Taxes Ahead?

I am proud to be an American and pay my fair share of taxes. Still, these proposals represent a massive tax increase on a lot of families. Many professional couples have the potential to have over $3.5 million before they pass away, and easily over $1 million in capital gains, too. We will keep you posted on this legislation. It seems likely that the two Acts will be merged and some compromise reached before a final version is up for a vote.

Luckily, there is a lot we can do to offset some of these proposed taxes and reduce the burden on your Estate and Heirs. Last minute strategies won’t work here, though. Families need to be thinking about their transfer of wealth years and decades ahead of time. Have questions on strategies if the step-up in basis is eliminated? Feel free to drop me an email.

Do You Have a College Fund?

Posted On August 21, 2020 By Scott Stratton, CFP(R), CFA In College Savings /

Do you have a college fund set up for your children or grandchildren? It is back to school time and that’s a little bit different this year. No one knows if the online classes will permanently change the process of education in the world. Still, I think there will be no substitute for the career benefits of having a degree in an in-demand field from a top notch school. Not everyone needs college, but overall, a higher education is strongly correlated to future earnings and career satisfaction.

The cost of a college education continue to climb. Student debt has become a crippling problem for many young adults I meet. They were told it would be worth it to get their degree, regardless the expense or their future earnings potential. Every parent wants the best for their kids, for them to have the opportunities we did not have. We want for them to be able to pursue their dreams and find their own unique greatness. Helping to pay for college goes a long way to setting up your kids to find their own Good Life.

Like most big financial goals, I think the best way to create a successful college fund is by making it automatic. Establish a 529 college savings account and make automatic contributions each month. If you can only start with $100 a month, great, just get started. Later, you can gradually bump that up to $200 or $300 a month or more.

How Much Should You Save?

A 529 plan will allow you to invest into a diversified allocation. The 529 Plan I use has Vanguard, iShares, and State Street index funds, just like I recommend in our Premiere Wealth Management portfolios. While no one knows future returns, let’s consider how your money might grow at 1%, 3%, or 6%. And then let’s also consider if you start at age zero, 5, and 10 for your kids. This would equate to 18, 13, and 8 years of growth to age 18 and the start of college.

Here is how $250 a month would grow:

There are two main points I think this chart makes. First, it pays to start your college fund early for compound interest. If you wait until your kids are 10, you might have only one-third the amount saved, compared to starting at birth. Second, you aren’t going to grow much if your money is in a bank account earning one percent. (By the way, at $250 a month, or $3,000 a year, you would have contributed a cumulative $54,000 over 18 years, $39,000 over 13 years, or $24,000 over 8 years.)

How to Get Started

A 529 College Savings Plan is an efficient way to create a College Fund, as distributions for qualified education expenses are tax-free. You can even start a 529 for an unborn child and change it to their name once they are born. The important thing is to get started early. Each state sponsors their own 529 Plan. If your state has income taxes, there may be a benefit for using the In-State plan. For Texas, since we don’t have an income tax, there is no inducement to use the Texas plan versus one from any other state. You can use any plan at any college in the country.

While you could save in a regular account for college, there are valuable tax benefits in 529 Plans. Most investors prefer to have different buckets for different goals. This helps address savings goals. Even if your kids are 10 or older, it’s not too late to start your college fund. We are accepting new clients and want to help you get started.

If you’d like an estimate what it might cost