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Replace the Stretch IRA?

Today's rules have created a lottery system, and those under consideration in Washington would only make things more complicated.

Under today's law, a beneficiary who inherits an IRA (or other tax-favored retirement plan) has the option to continue the tax-deferred status of the benefits by electing a "life expectancy payout." Code section 401(a)(9) requires the beneficiary to take annual "required minimum distributions" over his life expectancy. Except for this annual distribution, the IRA can stay in its tax-deferred state for years or even decades, depending on how old that beneficiary was when she inherited the account. A newborn beneficiary could achieve an 80-year deferred payout!

This "life expectancy payout" system is great ... for a few people. Namely, the few beneficiaries who are lucky enough to inherit an IRA that was properly set up for them to qualify for the life expectancy payout, and who are young enough to have a long life expectancy to "stretch" the payments over, and who are knowledgeable enough to take advantage of it.

But what about the rest of us? As it turns out, unfortunately, most IRA owners and beneficiaries do not benefit from the "stretch," because:

  • The life expectancy payout is available only if the deceased IRA owner named the individual as his "designated beneficiary." Many participants flub this step, causing their retirement benefits to pass to their estate rather than directly to family members. When benefits pass to an estate, the life expectancy payout is not available. Beneficiaries are stuck with at best a five- or 10-year payout.
  • A trust named as beneficiary can qualify for the life expectancy payout under IRS rules--but only if it meets stringent IRS requirements. Experience has taught that few estate planning practitioners have mastered these requirements. Even the IRS doesn't seem to understand the rules, since they've issued contradictory rulings interpreting them.
  • Most IRA owners are old when they die, so their beneficiaries tend to be older also--it is actually rare for an IRA to be left to a young individual who would qualify for a multidecade payout.
  • Even when the stretch payout is an option, many beneficiaries prefer an immediate cashout over a deferred payout.

In short, today's rules have created a lottery system; the payout period for your IRA depends on such wild cards as how old your beneficiaries are, how good your estate planning lawyer is, and whether you remember to fill out a beneficiary designation when you move your IRA to a new company.

There's only one guaranteed way to make today's system worse--pass the "reform" legislation recently under consideration in Washington. "RESA" would exponentially increase the complications of today's system. It would require vast IRS and private lawyer/accountant resources to be devoted to the issue of how fast benefits are to be paid out after the owner's death. It would not replace the complicated and uncertain life expectancy payout system in place today. Rather, that would be preserved, but only for certain people: namely, the IRAs of people who died before the new rules are enacted; benefits payable to minor, disabled, or "chronically ill" beneficiaries, or to beneficiaries who are less than 10 years younger than the decedent; and the first $450,000 of benefits payable to everybody else.

So all the drawbacks of today's system would be preserved--with the added complication of allocating a $450,000 "life expectancy payout" amount among beneficiaries! Is this intended to be the tax advisors' full employment act?

The IRS would have to create new regulations declaring how the $450,000 "stretch-eligible" amount would be allocated among a decedent's retirement accounts and beneficiaries. The IRS, and all practitioners, would have to remain expert in the old system (which would still apply to many benefits) while also learning the new system. And the "lottery" feature of today's rules would be preserved--so if you forget to fill out your beneficiary form, or get poor advice about how to name a beneficiary, you and your family still lose big!

Meanwhile, most IRAs would be forced to pay out everything within five years after the owner's death. Benefits accumulated over a lifetime would thus be taxed in an accelerated and punitive fashion. This prospect will surely discourage people from saving for retirement in the first place.                                                            

There is a way Congress could replace today's system, and simplify it, without punishing those who saved much and invested well--legally--in reliance on today's tax system: Yes, get rid of the life expectancy payout, which currently operates like a lottery system. And, yes, replace it with a fixed term payout--just not a five-year payout.

The problem with the five-year payout is it's too short--it's punitive when it applies, so you have to make numerous exceptions (at least seven under current proposals). Instead, why not use a mandatory 21-year payout for everybody and all benefits? That period of time is long enough that it would not create unfairly highly taxed lump sums, so you would not need to make exceptions for sad cases, and it would not discourage people from contributing to retirement plans.

It would eliminate the lottery system, so that no longer would failure to name a beneficiary (or failure to hire an expert estate planning lawyer) destroy your IRA. Every beneficiary--whether young or old, including an estate or a trust--would get the same 21 years. It would be long enough so it should not be considered necessary to "grandfather" the benefits of people who died before the new law became effective--just let them switch to a fresh-start 21-year payout when the new law is enacted.

The only drawback of a 21-year fixed-term payout period for all retirement plan death benefits is it would reduce people's need for my services! I'll just have to get over it.

Where to read more: "RESA" is the Retirement Enhancement and Savings Act, a Senate bill advanced toward the end of 2016 with bipartisan support. Section 501 of that proposed legislation contained the modification of the post-death minimum distribution rules described above; variations of this proposal have been advanced several times in recent years.

Now available in electronic edition! By popular demand, Natalie Choate's book Life and Death Planning for Retirement Benefits has been published in an electronic version. The e-book edition gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Live links to cross-referenced book sections and most cited tax sources. Access anywhere you have an internet connection. Visit to subscribe or learn more.

The author is a freelance contributor to The views expressed in this article may or may not reflect the views of Morningstar.