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Mark Miller: Remaking Retirement

New Retirement Law Throws IRA Heirs a Curveball

Contributor Mark Miller discusses the death of stretch IRAs contained in the SECURE Act--and how retirement planners are scrambling to respond.

Talk about last minute: Congress passed important retirement legislation just before the holidays that has sent financial planners and tax professionals scrambling, because the law's impact on high-net-worth clients is nearly immediate.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act contains a grab bag of changes to our retirement system. The bill has been bouncing around in Congress for several years, and two of its most notable features have been getting most of the attention. One aims to improve coverage of workers in 401(k) plans by making it easier for small employers to join together in multiple employer plans, or "open MEPs." Another eases the path for employers to add annuities to their 401(k) plan menus.

Those parts of the SECURE Act will play out over many years.

But a lesser-noticed provision will have an immediate impact on the estate plans of people with large tax-deferred IRAs or 401(k)s.

The law eliminates the so-called "stretch" IRA, which allowed nonspouse beneficiaries to draw down inherited tax-deferred accounts over the course of their lifetimes. Heirs will now be required to draw down the entire account amounts within a 10-year window--a change that will have negative tax and financial-planning consequences in many cases.

The provision has sent high-net-worth households and their planners back to the drawing boards--and quickly, since the law took effect this month.

There are a few exceptions (more on that below). But most people expecting to pass along tax-deferred assets will want to review their plans.

That could include people with large sources of guaranteed income, including Social Security and pensions, or simply people with very large portfolios that extend beyond their own spending needs.

Under the old stretch rules, inherited IRAs could be drawn down over the lifetime of the heir, based on a schedule tied to his or her own life expectancy. Leon LaBrecque, a CPA with Sequoia Financial Group, offers this example in a piece he wrote recently on the death of the stretch for Forbes:

"For example, if 'Grandfather A' left his IRA to his 25-year-old granddaughter, she could, based on her life expectancy, take distributions over 57.2 years. If she inherited a $1 million IRA, her first-year distribution would be $1,000,000/57.2 or about $17,482. Depending on her other income, she could pay federal taxes anywhere from about $548 (if the RMD was her only income) to about $6,468 (if she were in the highest bracket). Her inherited IRA, if it grew at a rate of 7%, would expand to about $1.75 million in 10 years, and keep growing for most of her life."

From a policy standpoint, I'd argue this type of use subverts the intent of the tax-favored status of IRAs. The idea is to help individuals fund their retirements, not to pass along tax-favored assets to heirs.

"Prior to the SECURE Act, wealthy people have used IRAs not just for retirement but as tax shelters for themselves and their children," says Jeffrey Levine, CEO and director of financial planning at Blueprint Wealth Alliance. "The time period for drawing down wasn't just the IRA owner's lifetime, but those of her spouse, kids, or grandchildren."

So, tightening up the rule makes sense--although Congress should have set a longer deadline for the change to become effective. Under the SECURE Act, nonspouse beneficiaries must draw down all assets from inherited IRAs within 10 years. (The new restrictions apply to retirement plans owned by people who die after Dec. 31, 2019; beneficiaries who inherited plans in the years before 2020 are grandfathered under the old stretch rules.)

The new rules can create problems for heirs from a tax perspective, notes Ed Slott, an author and retirement expert who is one of the nation's leading authorities on individual retirement accounts.

"Let's say you die in your 80s--your children might well be inheriting these accounts from you in their 50s, which are likely to be their peak earning years," he says. "They'll be in their personal highest tax brackets--and who knows what tax rates will be at that point?"

Along with tax inefficiency, the income could have a variety of other negative consequences for heirs depending on their life stages, such as income-related monthly adjustment amounts (IRMAA) for Medicare premiums, taxation of Social Security benefits, or even applications for college aid for children.

Revisiting Roths
One likely impact of the death of the stretch IRA: Roth conversions will become more attractive for people aiming to pass along these assets to heirs rather than using them to fund their own retirements.

Inheritors of Roths still must draw them down after 10 years, but those withdrawals will be less troublesome since they will be tax-free.

"The law simply says you must take out the money after 10 years," notes Slott. "Your heirs could simply leave the Roth alone for 10 years and let the assets grow tax-free--and then take a lump sum. All that growth is tax-free, and it comes out tax-free," Slott adds.

This flexibility means an inherited Roth could be used by heirs in some interesting ways. For example, say your child inherits a Roth at age 60 and retires at 65. She could use those tax-free drawdowns to pay for living expenses while delaying her Social Security filing to age 70 in order to earn delayed retirement credits.

The next few years will be especially attractive for Roth conversions because of current income tax rates, as legislated under the Tax Cuts and Jobs Act of 2017. Those rates expire after 2025, and where they will go from there is, of course, an unknown--and of course they could be repealed earlier, if Democrats sweep the elections later this year.

Either way, Slott suspects tax rates have nowhere to go but up.

"Strike now, while you know rates are low," he advises.

Slott advises doing a series of small conversions over a number of years, filling up to the top of your tax bracket. It's much better not to fund the tax bill from the withdrawn amounts, so make sure you can cover the tax bill. Slott also notes that the Tax Cuts and Jobs Act did away with Roth conversion re-characterizations (or "do-overs"), so proceed with caution.

Exceptions to the Rule
In this article, Slott discusses the complex impact of the new rules on trusts. He also reviews some types of beneficiaries who are exempt from the stretch IRA clampdown. This group includes surviving spouses, minor children, disabled and chronically ill people, and individuals not more than 10 years younger than the IRA owner. (Slott also discusses the option to leave life insurance policies to heirs via trusts and qualified charitable distributions.)

And Levine notes a couple of other temporary exceptions and reprieves.

The effective date of change is delayed for retirement plans covered by collective bargaining agreements, governmental plans (including the Thrift Savings Plan), and some qualified annuities that already have been annuitized over the life/joint life of their owners. For those accounts, the new rules kick in for deaths occurring in 2022 and beyond.

Review Beneficiaries
Levine urges everyone to review beneficiary designations in light of the new rules.

"There is no exception to this--every single beneficiary should be looked at," he says. "Perhaps you had set this up so that a spouse is the beneficiary of your life insurance policy, and your kids or grandkids inherit your IRA--that may not make sense anymore."

Other Noteworthy Changes
The SECURE Act also contains two changes that respond to the trends of rising longevity and people working longer. Taken together, these changes aim to help people save more and longer, and to retain assets for a longer period of time. The restriction prohibiting contributions to IRAs after age 70 has been lifted, and the age at which you must take RMDs from IRAs or 401(k) plans is bumped up to 72 1/2 from 70 1/2 currently.

It's a lot to absorb--financial planners and tax professionals are working overtime to figure it all out for their clients. Everyone else should be paying attention, too.

For a broader discussion of the SECURE Act, check out my recent podcast interview with Melissa Kahn, managing director of retirement policy for the defined-contribution team at State Street Global Advisors.

Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to WealthManagement.com and the AARP magazine. He publishes a weekly newsletter on news and trends in the field at Retirement Revised. The views expressed in this column do not necessarily reflect the views of Morningstar.com.