How The Death Of The 'Stretch IRA' Could Give New Life To Roth IRAs

by: Evan Powers

Summary

The Senate Finance Committee recently recommended the repeal of the "stretch IRA," which enables non-spouse beneficiaries to spread distributions out over their own life expectancy, rather than the account owner's.

If the "stretch IRA" is repealed, then individuals with large IRA balances might inadvertently leave large tax bills to their heirs, as accelerated IRA distributions fall in peak earning years.

A systematic and strategic series of smaller Roth conversions might provide a sort of cross-generational tax arbitrage, taking into consideration both the account owner's tax rate and the beneficiaries' rates.

The growing allure of the Roth IRA could gain significant momentum as a result. Already, younger workers are embracing the Roth. Now, retirees might begin embracing it as well.

With just one week remaining until a historic change of power in Washington, D.C., policy uncertainty is at levels not seen in decades. Almost every area of the economy is seemingly in flux as the nation awaits some level of clarity on President-elect Donald Trump's policies, which may or may not come soon after his inauguration. From healthcare to energy policy to trade agreements to tax policy and even the relationship between the executive branch and the Federal Reserve, the potential for landscape-altering policy shifts is significant and daunting.

Against that potentially volatile backdrop, you'd be forgiven for not noticing an under-the-radar piece of legislation that could significantly reshape the future of our retirement plans (and the tax implications for our beneficiaries). The proposed law pertains to the so-called "stretch IRA," a savings withdrawal method that has long provided a tax-deferral boon to those who have been fortunate enough to inherit 401(k) or IRA assets from deceased loved ones.

While legal challenges to the stretch IRA have been common in recent years, previous efforts have mostly withered on the vine awaiting congressional approval. Buoyed by the potential revenue-raising implications of a repeal, though, the Senate Finance Committee voted 26-0 in September to recommend a proposed bill that would kill the stretch IRA, albeit with some caveats. The Senate proposal was subsequently included in a bill named the "Retirement Enhancement and Savings Act," and a vote on the measure could come early in 2017.

So, what is the "stretch IRA," and why does it matter to you? Should the bill cause you to take a second look at the beneficiary designations on your existing retirement accounts (or, perhaps, should you be doing that already)? We'll take a quick look at the basics of beneficiary designations, the potential implications of the death of the stretch IRA, and what you can do to mitigate any negative impacts.

Why beneficiaries matter

One of the main functions of any well-considered estate plan is to ensure a smooth and expeditious distribution of assets upon one's death. Retirement accounts like 401(k) plans and IRAs are particularly convenient in this regard, since essentially all of them allow the account owner to designate a number of different beneficiaries (both primary and contingent) to whom the assets are required to pass upon the owner's death. A potentially long and costly probate process can be avoided, and legal challenges to beneficiary designations are essentially non-existent.

Beneficiary designations are therefore extremely powerful - not only do they allow assets to automatically avoid probate, they also override any other stipulations made in a will, trust, or other estate planning document. If your beneficiary designations are at odds with your broader wishes, then your will may end up becoming little more than a trivial piece of paper.

For married individuals, an account owner should usually name his or her spouse as the primary beneficiary - spouses have the most flexibility with how to treat inherited retirement accounts, and in many cases (and many states), account owners are required to obtain spousal consent if they wish to name anybody but their spouse as primary beneficiary.

That doesn't mean, though, that beneficiary designations should ever be ignored or left up to the courts (or "default" options). Distribution options are always maximized when there is a specific, named beneficiary listed on an account - it's therefore important not only to explicitly list a primary beneficiary, but also to name specific contingent beneficiaries, as well.

The primary benefit of being a "named non-spouse" beneficiary (whether primary or contingent) is the availability of the "stretch IRA." Under the stretch IRA provision, if a named beneficiary properly opens and funds an "inherited IRA," the beneficiary will be eligible to withdraw account funds gradually over time, in accordance with their own life expectancy.

For younger beneficiaries who may have several decades of life expectancy remaining (according to the IRS' "Single Life Expectancy" table), this provision allows them to "stretch" the tax-deferral benefit over a long time period, thus maximizing the tax benefits that accrue to them as beneficiaries. In some cases, the benefit could even be stretched to a third or fourth generation, depending on the initial size of the IRA and the life spans of the beneficiaries in question.

However, if a 401(k) or IRA account has no named beneficiaries (or if all named beneficiaries are already deceased, or if the named beneficiary is a charity or a trust), then the stretch IRA option is automatically eliminated. Whoever does ultimately receive the assets will generally default to the so-called "five-year rule," in which all account assets are required to be distributed within five years of the original account owner's death. Given the potentially sizable benefits of stretching the tax-deferral benefit, this outcome both can and should be avoided.

Implications of the proposed bill

The large tax-deferral benefits of the stretch provision are also the reason for its proposed repeal. While the exact figures remain the subject of debate, members of the Senate Finance Committee estimate a positive budgetary impact of $5.5 billion over a 10-year period. That's not a huge deal in the context of a $3.8 trillion annual federal budget, but it's enough to spark congressional attention, so here we are.

Even if the stretch provision is repealed, however, it's important to note that the impact will be limited. Spousal beneficiaries will still have the option of rolling an inherited IRA into their own IRA, enabling them to withdraw funds based on their own life expectancy. And because Roth IRA distributions are not taxed when they are withdrawn, Congress has no pressing reason to force Roth IRA beneficiaries to withdraw their funds on an accelerated basis - Roth accounts are therefore expected to be left alone by any future repeal of the stretch IRA provision. Certain dollar-amount exclusions may also be instated, but those details are not yet fully known.

In the event that the stretch IRA is in fact killed, IRA beneficiaries - particularly younger, prime-working-years beneficiaries - could find themselves pushed into the highest tax bracket as potentially large, six-figure IRA distributions are added to their other sources of income. One strategy that retirees with large IRA balances might consider is a system of aggressive Roth IRA conversions. Especially if spread over a number of years, these conversions can occur at lower tax rates than the high rates that beneficiaries would eventually face, thus saving on total lifetime tax bills.

At an extreme level, the removal of the stretch IRA option could even turn the conventional wisdom of the traditional-versus-Roth IRA decision on its head. Historically, the most common advice has been to contribute to a Roth (or perform a Roth conversion) when your tax rate is low, and you expect your retirement years tax rate to be higher than it is today. In all other cases, a traditional IRA contribution (a salary deferral, in essence) is recommended, since the saver can defer taxes from a high-tax year into a lower-tax year.

With the stretch IRA removed, though, it's not just the individual saver's tax rate that needs to be considered. The tax rates of any potential beneficiaries need to be taken into account, as well, lest the saver inadvertently "defer" income right into a future beneficiary's peak earning years.

With a stretch IRA, the annual distributions are usually small enough (and spread over enough years) that the tax rate of the beneficiary is a secondary consideration, at best. But if large balances are forced to be distributed across a five-year period, then the tax bite could be significant, and an otherwise sound decision could be invalidated due to improper long-term (and estate-focused) planning.

If you're likely to outlive your IRA assets, then decisions about Roth contributions and Roth conversions need to become a standard part of the estate planning process. Beneficiary designations alone are only half the battle; actually knowing and understanding the financial situation of your beneficiaries is also vital.

With the future of the stretch provision in doubt, it's now more important than ever to understand the implications of our beneficiary designations, and the tax impacts that inheritances may have on our heirs. Thoughtful strategies on the front end can yield benefits for multiple generations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The author is a contract employee and partial owner of myFinancialAnswers.com, and he is compensated to provide industry commentary for the site. The opinions provided here may also be published at myFinancialAnswers.com.

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