Stretch IRA Rules

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.

  1. A Spouse
  2. Minor Children (see below)
  3. Disabled Persons
  4. Chronically Ill Individuals
  5. Persons Not more than 10 years younger than the IRA owner
  6. 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!

SECURE Act Retirement Bill

Tax Savings under the SECURE Act

A few weeks ago, we gave an overview of key changes under the SECURE Act Retirement Bill. Today we are going to dive into a few questions that investors have been asking about the Act. Here’s how the SECURE Act can help you reduce your tax bill.

RMDs and QCDs

1. Required Minimum Distributions are pushed to age 72 from 70 1/2. If you turned 70 1/2 in 2019, even though you won’t reach 72 in 2020, you will still be responsible for taking RMDs. You will not get to skip a year. 

2. Although RMDs have been pushed to 72, the age for Qualified Charitable Distributions (QCDs) was unchanged at age 70 1/2. I’ve read some articles suggesting people under 72 not do QCDs now. Sure you could wait until after 72 to count a QCD towards your RMD. However, most donors I know want to support their favorite charities annually. So if you are 70 1/2 and want to make a $5,000 charitable donation this year, consider three scenarios:

  • You could make a cash donation. To be able to deduct your charitable donations, you have to have more than $12,400 (single) or $24,800 (married) in itemized deductions for 2020  It’s likely that a $5,000 donation nets you no tax benefit.
  • Or you could donate appreciated securities. If you had a $5,000 position with a $2,500 cost basis, donating those shares would save you $375 in long-term capital gains. (Most tax payers are in the 15% LT rate.)
  • With a QCD, it wouldn’t save you any taxes this year. But it would remove $5,000 from your IRA, saving you in future taxes. If you are in the 24% tax bracket, that would save $1,200 in future income taxes. That’s still the best choice of these three options.

529 Plans Can Pay Student Loans

3. Beneficiaries of a 529 College Savings Plan can now use their account to pay up to $10,000 in student loans. This will help those who have finished and have leftover funds. But also, there could be an advantage to deliberately taking $10,000 in Stafford Loans in the first or second year of college to receive deferment on the loan until after you’ve graduated. Then the funds can grow for four or so years while the student receives a loan which has no payments or interest accruing. Upon the end of the deferment period, you could use the 529 to pay off the loan in full. Additionally, owners of a 529 plan can also use the funds to pay $10,000 towards a sibling’s student loans, should the original beneficiary not need the funds.

Stretch IRA Eliminated in 2020

4. With the elimination of the Stretch IRA, we previously shared tax saving strategies for owners of larger IRAs. Here’s one additional approach for a married couple who both have IRAs and plan to leave them to their children. Assuming both spouses have more funds than they will need in their lifetime, consider making your children the primary beneficiaries of your IRAs. Otherwise, the traditional approach of leaving each IRA to the spouse will ultimately double up the tax burden on the children as well as increasing RMDs for the surviving spouse. Since all inherited IRAs must be distributed in 10 years or less, it may be more tax efficient for the children to receive two distributions spread out, rather than one combined inheritance from the second-to-pass parent. Contact me for an examination of your specific situation. 

Annuity for Retirement Income?

5. 401(k) plans can now offer annuities for retirees to create a guaranteed income stream. This sounds like a big deal, but you have always been able to do this once you roll over your 401(k) into an IRA. And it still might be better to buy an annuity in an IRA for a couple of reasons:

  • You could shop for the best annuity product for you. Otherwise, you are stuck with whatever the plan sponsors have decided to offer. It could be that another insurance company offers higher payout rates. Contact me for quotes if this is something you are considering.
  • Your State Insurance Guaranty Association probably only protects $250,000 in losses should an Insurance Company go bankrupt. Some of the biggest ones, including AIG, almost failed back in 2009. If I had $400,000 or $600,000 to invest in annuities, you bet I’m going to divide that between two or three companies to stay under the covered limits. (Read more on the Texas Guaranty Association.)

Changes in law are common and an important reason for having an on-going financial plan with a professional who is staying informed. If you have questions about how the SECURE Act Retirement Bill could be beneficial or detrimental to your situation, please contact me. Our first meeting is always free.

SECURE Act Abolishes Stretch IRA

The SECURE Act passed in December and will take effect for 2020. I’m glad the government is helping Americans better face the challenge of retirement readiness. As a nation, we are falling behind and need to plan better for our retirement income. 

It’s highly likely that the SECURE Act will directly impact you and your family. Six of the changes are positive, but there’s one big problem: the elimination of the Stretch IRA. We’re going to briefly share the six beneficial new rules, then consider the impact of eliminating the Stretch IRA.

Changes to RMDs and IRAs

1. RMDs pushed to age 72. Currently, you have to begin Required Minimum Distributions from your IRA or 401(k) in the year in which you turn 70 1/2. Starting in 2020, RMDs will begin at 72. This is going to be helpful for people who have other sources of income or don’t need to take money from their retirement accounts. People are living longer and working for longer, so this is a welcome change.

2. You can contribute to a Traditional IRA after age 70 1/2. Previously, you could no longer make a Traditional IRA contribution once you turned 70 1/2. Now there are no age limits to IRAs. Good news for people who continue to work into their seventies!

3. Stipends, fellowships, and home healthcare payments will be considered eligible income for an IRA. This will allow more people to fund their retirement accounts, even if they don’t have a traditional job.

529 and 401(k) Enhancements

4. 529 College Savings Plans. You can now take $10,000 in qualified distributions to pay student loans or for registered apprenticeship programs.

5. 401(k) plans will cover more employees. Small companies can join together to form multi-employer plans and part-time employees can be included

6. 401(k) plans can offer Income Annuities. Retiring participants can create a guaranteed monthly payout from their 401(k). 

No More Stretch IRAs

7. The elimination of the Stretch IRA. This is a problem for a lot of families who have done a good job building their retirement accounts. As a spouse, you will still be allowed to roll over an inherited IRA into your own account. However, a non-spousal beneficiary (daughter, son, etc.) will be required to pay taxes on the entire IRA within 10 years.

Existing Beneficiary IRAs (also known as Inherited IRAs or Stretch IRAs) will be grandfathered under the old rules. For anyone who passes away in 2020 going forward, their IRA beneficiaries will not be eligible for a Stretch.

If you have a $1 million IRA, your beneficiaries will have to withdraw the full amount within 10 years. And those IRA distributions will be taxed as ordinary income. If you do inherit a large IRA, try to spread out the distributions over many years to stay in a lower income tax bracket. 

For current IRA owners, there are a number of strategies to reduce this future tax liability on your heirs.
Read more: 7 Strategies If The Stretch IRA Is Eliminated

If you established a trust as the beneficiary of your IRA, the SECURE Act might negate the value and efficacy of your plan. See your attorney and financial planner immediately.

IRA Owners Need to Plan Ahead

The elimination of the Stretch IRA is how Congress is going to pay for the other benefits of the SECURE Act. I understand there is not a lot of sympathy for people who inherit a $1 million IRA. Still, this is a big tax increase for upper-middle class families. It won’t impact Billionaires at all. For the average millionaire next door, their retirement account is often their largest asset, and it’s a huge change. 

If you want to reduce this future tax liability on your beneficiaries, it will require a gradual, multi-year strategy. It may be possible to save your family hundreds of thousands of dollars in income taxes. To create an efficient pre and post-inheritance distribution plan, you need to start now.

Otherwise, Uncle Sam will be happy to take 37% of your IRA (plus possible state income taxes, too!). Also, that top tax rate is set to go back to 39.6% after 2025. That’s why the elimination of the Stretch IRA is so significant. Many middle class beneficiaries will be taxed at the top rate with the elimination of the Stretch IRA. 

From a behavioral perspective, most Stretch IRA beneficiaries limit their withdrawals to just their RMD. As a result, their inheritance can last them for decades. I’m afraid that by forcing beneficiaries to withdraw the funds quickly, many will squander the money. There will be a lot of consequences from the SECURE Act. We are here to help you unpack these changes and move forward with an informed plan.

7 Strategies If The Stretch IRA is Eliminated

On May 31, I sent a newsletter about US House of Representatives approving the SECURE Act and six changes it would create for retirement plans. To pay for the cost of new rules, like extending the RMD age from 70 1/2 to 72, the legislation proposes to eliminate the Stretch IRA starting in 2020. While the Senate has yet to finalize their own version of this legislation, odds are good that something is going to get passed. And if the Stretch IRA manages to survive this time, it will likely be back on the chopping block in the near future.

A Stretch IRA, also known as an Inherited IRA or Beneficiary IRA, allows the beneficiary of an IRA to continue to enjoy the tax-deferred growth of the IRA and only take relatively small Required Minimum Distributions over their lifetime. Congress has recognized that while they want to encourage people to contribute to IRAs to save for their retirement, they’re not as happy about the IRAs being used as an Estate Planning tool.

If you have a large IRA, one million or more, you might have more in assets than you will need to spend. If you leave it to your spouse, they can still roll it into their own IRA and treat it as their own. Once the Stretch IRA is eliminated, and you leave the IRA to someone other than a spouse, they will have to withdraw the entire IRA within 10 years. Those distributions will be treated as ordinary income and there could be substantial taxes on a seven-figure IRA.

Now is the time to start planning for the end of the Stretch IRA. There are ways that could potentially save many thousands in taxes on a million dollar IRA. But these methods may take years to work, so it pays to start early. Here are seven considerations:

1. Charitable Beneficiary. If you are planning to leave money to a charity (a church, arts organization, university, or other charity), make that bequest through your IRA rather than from your taxable estate. The charity will receive the full amount and as a tax-exempt organization, not owe any taxes on the distribution. It will be much more tax efficient to leave taxable assets to individual beneficiaries and IRA assets to charities than the reverse.

2. QCD. Better than waiting until you pass away, you can donate up to $100,000 a year in Qualified Charitable Distributions after age 70 1/2 that count towards your RMD. This reduces your IRA but preserves a tax benefit today, which is even better than leaving it as an inheritance. Plus you get to see the good your donation can make while you are still alive. (And you don’t have to itemize your tax return; the QCD is an above the line deduction.)

3. Start withdrawals at age 59 1/2. The traditional approach to IRAs was to avoid touching them until you hit 70 1/2 and had to start RMDs. With today’s lower tax brackets, if you have a very large IRA, it may be preferable to start distributions as early as 59 1/2 and save that money in a taxable account.

For a married couple, the 24% tax bracket goes all the way up to $321,450 (2019). Those rates are set to sunset after 2025. Additionally, while any future growth in an IRA will eventually be taxed as ordinary income, IRA money that is withdrawn and invested in ETFs now will become eligible for the preferential long-term capital gains rate of 15%. Your future growth is now at a lower tax rate outside the IRA.

4. If you’re going to take annual distributions and pay the tax gradually, an even better way is through Roth Conversions. Once in the Roth, you will pay no tax on future growth and you heirs can receive the Roth accounts income tax-free. Conversions don’t count as part of your RMD, so the best time to do this may be between 59 1/2 and 70 1/2. Look at gradually making partial conversions that keep you within a lower tax bracket.

5. A lot of owners of large IRAs want to leave their IRA to a Trust to make sure the funds are not squandered, mismanaged, or taken by a child’s spouse. Unfortunately, Trust taxes are very high. In fact, Trusts reach the top tax rate of 37% once they hit just $12,750 in taxable income. In the past, trust beneficiaries were able to still use the Stretch IRA rules even with a Trust. However, if the Stretch IRA is eliminated, most of these IRA Trusts are going to pay an egregious amount of taxes.

One alternative is to establish a Charitable Remainder Trust (CRT). This would allow for annual income to be provided to your beneficiaries just like from a Stretch IRA, but once that beneficiary passes away, the remainder is donated to a charity. This preserves significant tax benefits as the initial IRA distribution to the CRT is non-taxable. The downside is that there are no lump sum options and the payments will not continue past the one generation named as beneficiaries. 

Still, if you have a Trust established as the beneficiary of your IRA, you will want to revisit this choice very carefully if the Stretch IRA is eliminated.

6. Life Insurance. I usually recommend Term Insurance, but there is a place for permanent life insurance in estate planning. If the Stretch IRA is repealed, it may be more efficient to use your IRA to pay for $1 million in life insurance than to try to pass on a $1 million IRA. Life insurance proceeds are received income tax-free by the beneficiary.

For example, a healthy 70 year old male could purchase a Guaranteed Universal Life Policy with a $1 million death benefit for as little as $24,820.40 a year. Take the RMD from your $1 million IRA and use that to pay the life insurance premiums. Now your heirs will receive a $1 million life insurance policy (tax-free) in addition to your $1 million IRA. This policy and rate are guaranteed through age 100. If you don’t need income from your IRA, this could greatly increase the after-tax money received by your heirs. 

7. If you are an unmarried couple, you might want to consider if it would be beneficial to be married so that one spouse could inherit the other’s IRA and be able to treat it as their own.

The elimination of the Stretch IRA has been proposed repeatedly since 2012. In some ways, its repeal is a new inheritance tax. Billionaires typically have little or insignificant IRA assets compared to the rest of their wealth and have access to complex trust and legal structures. However, working professionals who have diligently created a net worth of $1 to 4 million, likely have a substantial amount of their wealth in their retirement accounts. And these are the families who will be impacted the most by the elimination of the Stretch IRA.

If you are planning on leaving a substantial retirement account to your beneficiaries, let’s talk about your specific situation and consider what course of action might be best for you. 

6 Changes Congress Wants to Make to Your Retirement Plan

In a rare bipartisan vote of 417-3, the House of Representatives approved the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. The Act now goes to the Senate, which may make modifications, but is likely to still pass and reconcile a version of this legislation.

The version passed by the House has provisions which will indeed enhance 401(k)s, IRAs, and other retirement plans for all Americans. Hopefully, this will get more people saving and starting their contributions at a younger age. There are also provisions which will help retirees and people over age 70.

Here’s a partial list of the changes in the legislation:

  1. Pushing back the age for Required Minimum Distributions (RMDs) from 70 1/2 to 72.
  2. Allowing workers over age 70 1/2 to continue to contribute to a Traditional IRA.
  3. Allowing up to $5,000 in penalty-free withdrawals from IRAs to cover birth or adoption expenses for parents (taxes would still apply, but the 10% penalty would be waived).
  4. Allowing up to $10,000 in withdrawals from 529 College Savings Plans to pay off student loans. 
  5. Requiring 401(k) statements to show participants how much monthly income their balance could provide.
  6. Eliminating the “Stretch IRA”, also known as the Inherited or Beneficiary IRA. Currently, a beneficiary can take withdrawals over their lifetime. Instead, they will be required to withdraw all the money – and pay taxes – within 10 years.

The first two reflect the reality of how poorly prepared some Baby Boomers are for retirement and that more people are working well into their seventies today. Pushing back the RMD age will help people save for longer and reflects that life expectancy has gone up significantly since the original RMD rules were established decades ago.

Read more: Stop Retiring Early, People!

I am also a fan of showing the expected income from a 401(k). The SECURE Act will make it easier for 401(k) plans to offer participants the ability to purchase an immediate annuity and create monthly income from their retirement account. Lump sums tend to look very impressive, but when we consider making that money last, it can be a bit disappointing. 

For example, a 65-year old male with $100,000 could receive $529 a month for life. $100,000 sounds like a lot of money, but $529 a month does not. I would point out that $529 for 12 months is $6,348 a year which is a lot more than the 4% withdrawal rate we usually recommend for new retirees. (But the 4% would increase for inflation, whereas the annuity will remain $529 forever.)

Read more: How to Create Your Own Pension

The provision eliminating the Stretch IRA will be problematic for people with large IRAs. I am hoping that they will continue to allow a surviving spouse to treat an inherited IRA as their own, as is currently the law. If they do eliminate the Stretch IRA, there are several strategies which we might want to consider to reduce taxes on death. 

  • Rather than leaving taxable accounts to charity, it would be preferable to make the charity a beneficiary of your IRA. They will pay no taxes on receiving your IRA, unlike your family members. Also, you can change the charities easily through an IRA beneficiary form and not have to rewrite your will or hire an attorney.
  • You might want to leave smaller portions of your IRA to more people. Four people inheriting a $1 million IRA will pay less in taxes than one person, unless all four are already in the top tax bracket. Consider if making both children and grandchildren as a beneficiaries might help lower the tax bill on your beneficiaries. (Check with me about the Generation Skipping Tax, first. Your estate may be below the GST threshold.)
  • You could convert your IRA to a Roth, pay the taxes now and then there are no RMDs and your beneficiaries will inherit the Roth tax-free. You can spread the conversion over a number of years to stay in a lower tax bracket. Today’s low tax rates are supposed to sunset after 2025.

I will plan a full article on these strategies if the Stretch IRA is in fact repealed; we don’t know yet if existing Stretch IRAs will be grandfathered in place. This is the only negative I see in the legislation, and it will impose a higher tax burden on many beneficiaries of my clients’ retirement plans. There have been proposals to eliminate the Stretch IRA since at least 2012, but it just might happen this time.

While someone with $1 million or $2 million in a 401(k) is fairly well off, the reality is that this would be imposing a much higher tax burden on the beneficiaries of an IRA than for a genuinely wealthy family who has $10 million in “taxable” assets which will receive a step-up in cost basis upon death. The Ultra-Wealthy don’t have significant assets in IRAs, so this won’t really have an impact on them or their families, but for middle class folks, their retirement accounts are often their largest assets. Stay tuned!

Will the IRS Inherit Your IRA?

sign-for-internal-revenue-service

For several years, there has been a proposal in Washington to eliminate the Stretch IRA, also known as the “Inherited IRA” or “Beneficiary IRA”. Currently, when your beneficiary inherits your IRA, they can keep the account tax-deferred by leaving the assets in a Stretch IRA. While they have to take Required Minimum Distributions, using a Stretch IRA keeps distributions small and taxes low, as well as encourages beneficiaries to use the money gradually rather than spend their inheritance immediately.

Congress is looking for new ways to reduce the budget deficit, and according to IRA expert Ed Slott, it is increasingly probable that the Stretch IRA will be eliminated in the near future. Forcing beneficiaries to withdraw their inherited IRAs will raise billions in tax revenue, while allowing politicians to say that they haven’t raised tax rates.

If the Stretch IRA is repealed, beneficiaries will have to withdraw all of an inherited IRA – and pay taxes on the distributions – within five years. For many retirees, their retirement accounts are their largest assets. Many have accumulated a significant sum, often $1 million or more. If your beneficiary receives a $1 million IRA in one year, regardless of whether they spend the money or invest it, they could owe up to $396,000 in income tax. Even spreading the withdrawal over  five years ($200,000 a year) will push any tax payer into a high tax bracket where the IRS will collect 28%, 33%, or more from your IRA.

If you aren’t touching your IRAs because you have other sources of retirement income, such as a pension, Social Security, or other investments, you may have been thinking that you would leave the IRA to your heirs and not take any withdrawals. It’s a very generous plan, but if the Stretch IRA is repealed, a significant amount of your IRA is going to end up in the pockets of the IRS.

What can you do to minimize the taxes and maximize the amount your heirs will receive? Here are three ways to accomplish this:

1) Buy life insurance. Use your IRA money to fund a permanent life insurance policy, such as a level premium Universal Life policy. Life insurance death benefits are received income tax-free. Purchase a $1 million policy for your beneficiaries and they will receive all $1 million tax-free.

For example, a healthy 65-year old male can purchase a $1 million Universal Life policy for as little as $17,218 per year. That is a sizable premium, but not a bad deal to guarantee your heirs a $1 million payout, tax-free. While funding those premiums from your IRA does create taxes, the taxes paid will be lower if you take small withdrawals over a period of many years rather than leaving your heirs in a position of having to take the entire distribution over 5 years (or 1 year if they don’t do the distribution correctly).

If you don’t need the income from your RMDs, using those distributions to fund a life insurance policy may have a significant benefit for your heirs.

2) Leave to Charity. There is a way to pay no tax on your IRA on death and that is to leave the account to a charity. 501(c)(3) non-profit organizations will not have to pay any income tax when they are named as the beneficiary of your IRA or retirement accounts. If you were planning to leave something to charity, make sure that bequest is from your IRA and not from a regular account.

For example:

Scenario 1: You leave a $1 million taxable account to charity and a $1 million IRA to your daughter. The charity receives $1 million, but your daughter will owe taxes up to $396,000 on the IRA, leaving her with as little as $604,000.

Scenario 2: You leave the $1 million taxable account to your daughter and the $1 million IRA to the charity. The charity receives $1 million, your daughter receives $1 million (and a step-up in cost basis), and the IRS gets zip. Much better!

3) Spread out your IRA. If you leave $1 million to one beneficiary, they will have to pay tax on the entire amount. If you leave the IRA to 10 beneficiaries (perhaps grandchildren, nieces, nephews, etc.), the tax due will be much less on $100,000 for 10 tax payers than on $1 million received by one person.

Please note that spouses can roll their deceased spouse’s IRA into their own IRA and treat it as their own. If the Stretch IRA is repealed, this may not be a problem for leaving an IRA to your spouse. However, if your spouse consolidates both of your IRAs into one account, the tax problem for the subsequent heirs will have become even more significant.

The one good thing about IRAs is that you can change your beneficiaries at any time without having to re-do your Will and other documents in your Estate Plan. It is very important to remember that your IRA beneficiary designations override any instructions in your Will, so it is vital to have your beneficiary designations correct and up-to-date.

Not sure where to begin with your Estate Plan? We can help you find the right solution for your family, using our Good Life Wealth planning process. Interested in finding out more about life insurance? I’m an independent agent and can help you choose the best insurance policy for your goals. Call me with your questions, reducing taxes is my passion!