What Can I Do Instead of a Stretch IRA?

The idea of leaving a large inheritance to loved ones is a dream for some parents. However, without careful planning, heirs may end up with a large tax bill. When Congress passed the SECURE Act in December 2019, one of the changes was the end of the stretch IRA, as reported by Kiplinger in a recent article titled “Getting Around the Stretch IRA Block.”

Before the SECURE Act, people who inherited traditional IRAs needed to only take a minimum distribution annually, based on their own life expectancy. The money could grow tax-deferred for the rest of their lives. The tax impact was mild, because withdrawals could be spread out over many years, giving the new owner control over their taxable income. The rules were the same for an inherited Roth IRA. Distributions were based on the heirs’ life expectancy. Roth IRA heirs had the added benefit of not having to pay taxes on withdrawals, since Roth IRAs are funded with post-tax dollars.

After the SECURE Act, inherited traditional and Roth IRAs need to be emptied within ten years. Heirs can wait until the 10th year and empty the account all at once—and end up with a whopping tax bill—or take it out incrementally. However, it has to be emptied within ten years.

There are some exceptions: spouses, disabled or chronically ill individuals, or those who are not more than ten years younger than the original owner can stretch out the distribution of the IRA funds. If an underage minor inherits a traditional IRA, they can stretch it until they reach legal age. At that point, they have to withdraw all the funds in ten years—from age 18 to 28. This may not be the best time for a young person to have access to a large inheritance.

These changes have left many IRA owners looking for alternative ways to leave inheritances and find a work-around for their IRAs to protect their heirs from losing their inheritance to taxes or getting their inheritance at a young age.

For many, the solution is converting their traditional IRA to a Roth, where the IRA owner pays the taxes for their heirs. The strategy is generous and may be more tax efficient if the conversion is done during a time in retirement when the IRA owner’s income is lower, and they may be in a lower tax bracket. The average person receiving an IRA inheritance is around 50, typically peak earning years and the worst time to inherit a taxable asset.

Another way to avoid the stretch IRA is life insurance. Distributions from the IRA can be used to pay premiums on a life insurance policy, with beneficiaries receiving death benefits. The proceeds from the policy are tax-free, although the proceeds are considered part of the policy owner’s estate. With the current federal exemption at $12.06 million for individuals, the state estate tax is the only thing most people will need to worry about.

A Charitable Remainder Trust can also be used to mimic a stretch IRA. A CRT is an irrevocable split-interest trust, providing income to the grantor and designated beneficiaries for up to twenty years or the lifetime of the beneficiaries. Any remaining assets are donated to charity, which must receive at least 10% of the trust’s initial value. If the CRT is named as the IRA beneficiary, the IRA funds are distributed to the CRT upon the owner’s death and the estate gets a charitable estate tax deduction (and not an income tax deduction) for the portion expected to go to the charity. Assets grow within the charitable trust, which pays out a set percentage to beneficiaries each year. The distributions are taxable income for the beneficiaries. There are two types of CRTs: Charitable Remainder Unitrust and a Charitable Remainder Annuity Trust. An estate planning attorney will know which one is best suited for your family.

Reference: Kiplinger (March 3, 2022) “Getting Around the Stretch IRA Block”

Do You Have to Pay Taxes on Inherited IRAs?

If you’ve inherited an IRA, you won’t have to pay a penalty on early withdrawals if you take money out before age 59½. However, you may have to make those withdrawals earlier than you’d wanted. Doing so may trigger additional income taxes, and even push you into a higher tax bracket. The IRA has always been a complicated retirement account. While changes from the SECURE Act have simplified some things, it’s made others more stringent.

A recent article titled “How Do I Avoid Paying Taxes on an Inherited IRA?” from Aol.com explains how the traditional IRA allows tax-deductible contributions to be made to the account during your working life. If the IRA includes investments, they grow tax—free. Taxes aren’t due on contributions or earnings, until you make withdrawals during retirement.

A Roth IRA is different. You fund the Roth IRA with after-tax dollars, earnings grow tax free and there are no taxes on withdrawals.

With a traditional inherited IRA, distributions are taxable at the beneficiary’s ordinary income tax rate. If the withdrawals are large, the taxes will be large also—and could push you into a higher income tax bracket.

If your spouse passes and you inherit the IRA, you may take ownership of it. It is treated as if it were your own. Howwever, if you inherited a traditional IRA from a parent, you have just ten years to empty the entire account and taxes must be paid on withdrawals.

There are exceptions. If the beneficiary is disabled, chronically ill or a minor child, or ten years younger than the original owner, you may treat the IRA as if it is your own and wait to take Required Minimum Distributions (RMDs) at age 72.

Inheriting a Roth IRA is different. Funds are generally considered tax free, as long as they are considered “qualified distributions.” This means they have been in the account for at least five years, including the time the original owner was alive. If they don’t meet these requirements, withdrawals are taxed as ordinary income. Your estate planning attorney will know whether the Roth IRA meets these requirements.

If at all possible, always avoid immediately taking a single lump sum from an IRA. Wait until the RMDs are required. If you inherited an IRA from a non-spouse, use the ten years to stretch out the distributions.

If you need to empty the account in ten years, you don’t have to withdraw equal amounts. If your income varies, take a larger withdrawal when your income is lower and take a bigger withdrawal when your income is higher. This can result in a lower overall tax liability.

If you’ve inherited a Roth IRA and funds were deposited less than five years ago, wait to take those funds out for at least five years. When the five years have elapsed, withdrawals will be treated as tax-free distributions.

One of the best ways for heirs to avoid paying taxes on an IRA is for the original owner, while still living, to convert the traditional IRA to a Roth IRA, paying taxes on contributions and earnings. This reduces the taxes paid if the owner is in a lower tax bracket than beneficiaries, and lets the beneficiaries withdraw funds as they want with no income tax burden.

Reference: Aol.com (Feb. 25, 2022) “How Do I Avoid Paying Taxes on an Inherited IRA?”

What Is the Required Minimum Distribution for 2021?

There have been a number of changes to the requirements for RMDs—Required Minimum Distributions—from traditional retirement accounts, says a recent article titled “2 Essential Strategies for Taking Your RMDs” from Kiplinger. In 2019, the age for RMDs was raised from 70½ to 72. In 2020, they were waived altogether because of the pandemic. Now they’re back, and you want to know how to make good decisions about them.

Most people take the default approach, taking a lump sum of cash at the start or the end of the year. This is not the best approach. Investment markets and your own need for income are better indicators for how and when to take your RMD. If you can at all avoid it, never take an RMD from a declining market.

You can take your RMD anytime during the calendar year, from January 1 to December 31. If it’s the first time you’ve taken an RMD, you get a bonus: you can wait until April 1 of the year after your 72nd birthday. The RMD is calculated, by dividing the account balance on December 31 of the preceding year by your life expectancy factor, based on your age. You can find it in the IRS’s Uniform Lifetime Table.

2021 distributions will be bigger, and not just because of the market’s 2020 performance. Instead, distributions will be bigger because of how the accounts are designed, with RMDs becoming a larger percentage over time. It starts as a small percentage and eventually becomes the entire account, which is then depleted. Remember, the sole purpose of the RMD is to force retirees to take money out of their retirement accounts and pay taxes on the money.

Many retirees take RMDs because they need the money to live on. Here’s where money management gets tricky. It’s far easier to take smaller amounts of money at regular intervals, kind of like a paycheck, than taking a big amount once a year. We’re creatures of habit and are used to receiving income and managing it that way.

Distributions on a regular basis also fosters a better sense of how much money you have to live on, encouraging you to create and adhere to a budget.

If you don’t need the income, taking money through regular installments also has an advantage. It’s like the opposite of dollar-cost averaging. Instead of putting money into the market in small increments over time to even out market ups and downs, you’re taking money out of the market at regular intervals. You’re not cashing out at the market’s lowest point, or at the highest. And if you’re reinvesting RMDs in a taxable account, this strategy works especially well.

Reference: Kiplinger (June 10, 2021) “2 Essential Strategies for Taking Your RMDs”

What to Leave In, What to Leave Out with Retirement Assets

Depending on your intentions for retirement accounts, they may need to be managed and used in distinctly different ways to reach the dual goals of enjoying retirement and leaving a legacy. It’s all explained in a helpful article from Kiplinger, “Planning for Retirement Assets in Your Estate Plan”.

Start by identifying goals and dig into the details. Do you want to leave most assets to your children or grandchildren? Has philanthropy always been important for you, and do you plan to leave large contributions to organizations or causes?

This is not a one-and-done matter. If your intentions, beneficiaries, or tax rules change, you’ll need to review everything to make sure your plan still works.

How accounts are titled and how assets will be passed can create efficient tax results or create tax liabilities. This needs to be aligned with your estate plan. Check on beneficiary designations, asset titles and other documents to make sure they all work together.

Review investments and income. If you’ve retired, pensions, annuities, Social Security and other steady sources of income may be supplemented from your taxable investments. Required minimum distributions (RMDs) from tax deferred accounts are also part of the mix. Make sure you have enough income to cover regular and unanticipated medical, long term care or other expenses.

Once your core income has been determined, it may be wise to segregate any excess capital you intend to use for wealth transfer or charitable giving. Without being set apart from other accounts, these assets may not be managed as effectively for taxes and long-term goals.

Establish a plan for taxable assets. Children or individuals can be better off inheriting highly appreciable taxable investment accounts, rather than traditional IRAs. These types of accounts currently qualify for a step-up in cost basis. This step-up allows the beneficiary to sell the appreciated assets they receive as inheritance, without incurring capital gains.

Here’s an example: an heir receives 1,000 shares of a stock with a $20 per share cost basis valued at $120 per share at the time of the owner’s death. They will pay no capital gains taxes on the gain of $100 per share. However, if the same stock was sold while the retiree owner was living, the $100,000 gain in total would have been taxed. The post-death appreciation, if any, on such inherited assets, would be subject to capital gains taxes.

Retirees often try to preserve traditional IRAs and qualified accounts, while spending taxable accounts to take advantage of lower capital gains taxes as they take distributions. However, this sets heirs up for a big tax bill. Another strategy is to convert a portion of those assets to a Roth IRA and pay taxes now, allowing the assets to grow tax free for you and your heirs.

Segregate assets earmarked for charitable donations. If a charity is named as a beneficiary for a traditional IRA, the charity receives the assets tax free and the estate may be eligible for an estate deduction for federal and state estate taxes.

Your estate planning attorney can help you understand how to structure your assets to meet goals for retirement and to create a legacy. Saving your heirs from estate tax bills that could have been avoided with prior planning will add to their memories of you as someone who took care of the family.

Reference: Kiplinger (May 21, 2021) “Planning for Retirement Assets in Your Estate Plan”

How Does an Inherited IRA or 401(k) Work?
Inherited IRA written on a piggy bank

How Does an Inherited IRA or 401(k) Work?

The rules for inheriting retirement assets are complicated—just as complicated as the rules for having 401(k)s and IRA to begin with. Mistakes can be hard to undo, warns the article “Here’s how to handle the complicated rules for an inherited 401(k) or IRA” from CNBC.

The 2019 Secure Act changed how inherited tax deferred assets are treated after the original owner’s death. The options depend upon the relationship between the owner and the heir. The ability to stretch out distributions across the heir’s lifetime if the owner died on or after January 1, 2020 ended for most heirs. Exceptions are the spouse, certain disabled beneficiaries, or minor children of the decedent. Otherwise, those accounts must be depleted within ten years.

Non-spouses with flexibility include minor children. That’s all well and fine, but once the minor child turns 18 (in most states), the 10-year rule kicks in and the individual has 10 years to empty the account. Before that time, the minor child must take annual required minimum distributions (RMDs) based on their own life expectancy.

These required withdrawals typically begin when a retiree reaches age 72, and the amount is based on the account owner’s anticipated lifespan.

Beneficiaries who are chronically ill or disabled, or who are not more than ten years younger than the decedent, may take distributions based on their own life expectancy. They are not subject to the ten- year rule.

Beneficiaries subject to that ten-year depletion rule should create a strategy, including creating an Inherited IRA and transferring the funds to it. If the inherited account is a Roth or a traditional IRA, the process is slightly different. Distributions from a Roth IRA are generally tax-free, and traditional IRA distributions are taxed when withdrawals occur. One point about Roths—if you inherit a Roth that’s less than five years old, any earnings withdrawn will be subject to taxes, but the contributed after-tax amounts remain tax-free.

If an heir ends up with a retirement account via an estate, versus being the named beneficiary on the account, the account must be depleted within five years, if the original owner had not started taking RMDs. If RMDs were underway, the heir would need to keep those withdrawals going as if the original owner continued to live.

For spouses, there are more options. First, roll the money into your own IRA and follow the standard RMD rules. At age 72, start taking required withdrawals based on your own life expectancy. If you don’t need the income, you can leave the money in the account, where it can continue to grow. However, if you are not yet age 59½, you may be subject to a 10% early withdrawal penalty if you take money from the account. In that case, put the money into an Inherited IRA account, with yourself as the beneficiary.

IRAs and 401(k)s are complicated. Speak with your estate planning attorney to make an informed decision when creating an estate plan, so your inherited assets will work with, not against, your overall strategy.

Reference: CNBC (April 11, 2021) “Here’s how to handle the complicated rules for an inherited 401(k) or IRA”

What Do I Need to Know about Roth IRA Conversions?

People with large tax-deferred accounts they intend to leave to their children can eliminate a tax burden on their heirs, by converting the tax-deferred money over time. By doing the conversion this way, says a recent article from The Wall Street Journal entitled “Roth IRA Conversions: What You Need to Know,” the cost is manageable and the heirs won’t have to pay taxes.

For a Roth conversion, the owner pays income tax on every dollar converted, which makes sense for people who retire early and want to avoid higher taxes in the future, or when children inherit the assets.

Recent changes require account owners to start taking required minimum distributions at age 72. The withdrawals can be costly in two ways: pushing household income into a higher tax bracket and forcing Medicare premiums higher.

Withdrawals from a Roth IRA, on the other hand, are not taxed and have no required distributions. It is tax-free money, since taxes are already paid. It can be a cash fund as needed, or a tax-free legacy to heirs.

The interest in Roth conversion increased since Congress tightened rules for inheriting tax-deferred assets. In the past, heirs had a lifetime to take withdrawals from inherited IRA accounts. Now, only surviving spouses and a small group of other individuals have this option. For everyone else, there’s a ten-year window to empty the account, which means increased income tax bills, especially for heirs who are already in high tax brackets.

Those who do the conversion over an extended period of time eliminate a tax timebomb for heirs and funds can be invested more aggressively to maximize growth.

In the simplest type of conversion, the owner notifies the custodian of the account of their wish to move assets from the tax deferred account to the Roth account. They need to specify how much they want to move, what funds they want to move and what date they want the transaction to happen. When taxes are filed the next year, all of the money transferred is treated as ordinary income.

Doing this during a market decline is a smart move. One investor moved $200,000 of stock mutual funds during the market downturn, which cost him about $85,000 in federal and state taxes. The converted funds have since bounced back to around $320,000, above where they were before the market decline. Those gains in a tax-deferred account would have been taxable, but now, they are tax free.

Seniors who have low taxable income, but large tax-deferred accounts, might consider doing a conversion every year before reaching age 72, when they must begin taking required minimum distributions.

Reference: The Wall Street Journal (Nov. 19, 2020), “Roth IRA Conversions: What You Need to Know,”

How to Benefit from a Roth IRA and Social Security

When originally created, Social Security was designed to prevent the elderly and infirm from sinking into dire poverty. When most working Americans enjoyed a pension from their employer, Social Security was an additional source of income and made for a comfortable retirement. However, with an average monthly benefit just over $1,500 and few pensions, today’s Social Security is not enough money for most Americans to maintain a middle-class standard of living, says the article “3 Reasons a Roth IRA Is a Perfect Supplement to Social Security” from Tuscon.com. It’s important to plan for additional income streams and one to consider is the Roth IRA.

Roth IRAs can be funded at any age. Many seniors today are continuing to work to generate income or to continue a fulfilling life. Their earnings can be put into a Roth IRA, regardless of age. If you are still working but don’t need the paycheck, that’s a perfect way to fund the Roth IRA.

Withdrawals from a Roth won’t trigger taxes on Social Security benefits. If your only income is Social Security, you probably won’t have to worry about federal taxes. However, if you are working while you are collecting benefits, once your earnings reach a certain level, those benefits will be taxed.

To calculate taxes on Social Security benefits, you’ll need to determine your provisional income, which is the non-Social Security income plus half of your early benefit. If you earn between $25,000 and $44,000 as a single tax filer or between $32,000 and $44,000 as a married couple, you could be taxed as much as 50% of your Social Security benefits. If your single income goes past $34,000 and married income goes past $44,000, you could be taxed on up to 85% of your benefits.

If you put money into a Roth IRA, withdrawals don’t count towards your provisional income. That could leave you with more money from Social Security.

A Roth IRA is flexible. The Roth IRA is the only tax-advantaged retirement savings plan that does not impose Required Minimum Distributions or RMDs. That’s because you’ve already paid taxes when funds went into the account. However, the flexibility is worth it. You can leave the money in the account for as long as you want, so savings continue to grow tax-free. You can also leave money to your heirs.

While you don’t have to put your savings into a Roth IRA, doing so throughout your career—or starting at any age—will give you benefits throughout retirement.

Reference: Tuscon.com (Oct. 5, 2020) “3 Reasons a Roth IRA Is a Perfect Supplement to Social Security”

How to Make Beneficiary Designations Better
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How to Make Beneficiary Designations Better

Beneficiary designations supersede all other estate planning documents, so getting them right makes an important difference in achieving your estate plan goals. Mistakes with beneficiary designations can undo even the best plan, says a recent article “5 Retirement Plan Beneficiary Mistakes to Avoid” from The Street. Periodically reviewing beneficiary forms, including confirming the names in writing with plan providers for workplace plans and IRA custodians, is important.

Post-death changes, if they can be made (which is rare), are expensive and generally involve litigation or private letter rulings from the IRS. Avoiding these five commonly made mistakes is a better way to go.

1—Neglecting to name a beneficiary. If no beneficiary is named for a retirement plan, the estate typically becomes the beneficiary. In the case of IRAs, language in the custodial agreement will determine who gets the assets. The distribution of the retirement plan is accelerated, which means that the assets may need to be completely withdrawn in as little as five years, if death occurs before the decedent’s required beginning date for taking required minimum distributions (RMDs).

With no beneficiary named, retirement plans become probate accounts and transferring assets to heirs becomes subject to delays and probate fees. Assets might also be distributed to people you didn’t want to be recipients.

2—Naming the estate as the beneficiary. The same issues occur here, as when no beneficiary is named. The asset’s distributions will be accelerated, and the plan will become a probate account. As a general rule, estates should never be named as a beneficiary.

3—Not naming a spouse as a primary beneficiary. The ability to stretch out the distribution of retirement plans ended when the SECURE Act was passed. It still allows for lifetime distributions, but this only applies to certain people, categorized as “Eligible Designated Beneficiaries” or “EDBs.” This includes surviving spouses, minor children, disabled or special needs individuals, chronically ill people and individuals who are not more than ten years younger than the retirement plan’s owner. If your heirs do not fall into this category, they are subject to a ten-year rule. They have only ten years to withdraw all assets from the account(s).

If your goal is to maximize the distribution period and you are married, the best beneficiary is your spouse. This is also required by law for company plans subject to ERISA, a federal law that governs employee benefits. If you want to select another beneficiary for a workplace plan, your spouse will need to sign a written spousal consent agreement. IRAs are not subject to ERISA and there is no requirement to name your spouse as a beneficiary.

4—Not naming contingent beneficiaries. Without contingency, or “backup beneficiaries,” you risk having assets being payable to your estate, if the primary beneficiaries predecease you. Those assets will become part of your probate estate and your wishes about who receives the asset may not be fulfilled.

5—Failure to revise beneficiaries when life changes occur. Beneficiary designations should be checked whenever there is a review of the estate plan and as life changes take place. This is especially true in the case of a divorce or separation.

Any account that permits a beneficiary to be named should have paperwork completed, reviewed periodically and revised. This includes life insurance and annuity beneficiary forms, trust documents and pre-or post-nuptial agreements.

Reference: The Street (Aug. 11, 2020) “5 Retirement Plan Beneficiary Mistakes to Avoid”