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If the Stretch IRA is repealed, beneficiaries will have to withdraw all of an inherited IRA – and pay taxes on the distributions – within five years.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 It’s a very generous plan, but if the Stretch IRA is repealed, a significant amount of your IRA is going to end up in the pockets of the IRS.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!
