Understanding stretch IRAs
Individuals who hold IRAs typically list their spouse as the beneficiary. But, if they hold an IRA they don’t plan to use, they’ll typically name the youngest grandchild as the beneficiary. Why? Because by “stretching” out the life of the IRA, the tax advantages are increased. A stretch IRA works because younger beneficiaries have smaller required minimum distributions (RMDs) than the typical ones the IRS requires you to take at age 70 ½, so younger beneficiaries incur smaller tax bills. The end result is a longer accumulation period and a larger sum of money going to the beneficiaries.
Under current rules, if a 25-year-old inherited a $1M IRA, they would take a distribution over their life expectancy of 57.2 years. Their distribution would be approximately $17,482. Assuming a 24% tax bracket, the federal tax would be about $4,195.
Proposed changes to stretch IRAs
The House version, the SECURE Act, changes the stretch period to a maximum of 10 years, which means the beneficiary would have to withdraw all the money within 10 years. The Senate has its own version of the bill known as the Retirement Enhancement and Savings Act (RESA), which would allow a stretch on the first $400,000 of aggregated IRAs and the exceeding balance must be distributed within five years.
Using the $1M inherited IRA example above, the beneficiary could withdraw $100,000 per year for 10 years and pay $24,000 in taxes each year (assuming the same 24% tax bracket), or $40,000 in taxes if the beneficiary is a trust. If the Senate version passes and is signed by the president, non-spouse young beneficiaries would have to withdraw $200,000 per year and pay substantially more taxes. That’s a substantial increase in taxes compared to current law.
Impact on retirement planning
If either of these bills passes, the impact on retirement planning will be significant. If you’re passing down an IRA, you’ll likely want to consider how you can help your beneficiaries (who may even be minor children) pay the income taxes due without further eroding their inheritance. Using your life insurance policy to pay the income taxes is one option, though that means you’ll have to carry life insurance much longer than we’ve typically recommended.
A Roth IRA and Roth 401(k) could also be arranged to pass down wealth tax-free, but this becomes a complicated issue if you are self-employed or own your own business because your 401(k) and profit-sharing plans will also be affected by both the House and Senate bills. More on this below.
Impact on business
For years, all part-time employees who worked under 1,000 hours could be excluded from 401(k) and profit-sharing plans. If passed, the SECURE Act would allow employees who work at least 9.5 hours per week and have been with the employer for at least three consecutive years ( two years under the Senate version), “long-term part-time employees”, to contribute to a 401(k) and receive employer-matching and profit-sharing contributions. If that happens, we can’t help but think that many employers will decide to terminate these plans due to the expense.
Note that, under the current proposals, there would be no changes made to defined benefit plans. So, to eliminate part-time employees from a retirement plan, employers may need to consider a defined benefit plan instead of a profit-sharing plan. There are significant advantages to a defined benefit plan, including higher contribution limits, and the ability to make a tax-free distribution for medical expenses, assuming the defined benefit plan has a 401(k) component. Those are all things to discuss with your BGW team, of course.
What’s next
The ball is now in the court of the Ways and Means Committee. It will have to decide which version of the bill, the House’s version or Senate’s, will be adopted and sent to the president for signature. We’ll keep on top of this one for sure, as the potential impact on your personal and business long-term strategy is huge.
