Many people have never heard the term “stretch IRA.” Even fewer are aware that the stretch IRA was eliminated in 2019 by the Secure Act. It’s important to understand the new timeline of required minimum distributions (RMDs) from inherited IRAs.
What Was a Stretch IRA?
If you are a non-spousal beneficiary of an IRA, you used to be required to take RMDs based on your life expectancy. This is why it was referred to as a stretch IRA. You could let the account grow, tax-deferred, and only be required to distribute a small percentage per year. These distributions are taxed at the less-preferred ordinary income rate.
What Is the 10-Year Rule?
The stretch IRA was beneficial because it allowed you to defer most of the tax liability for your lifetime. You could stretch out your inherited IRA for decades! The new rule means that you’re now restricted to depleting your inherited IRA within a 10-year time frame. Instead of having a small RMD every year (most commonly starting at around 4% of the account value), you now have just one RMD – December 31st, 10 years after the original IRA owner passed. The account must have a $0 balance on that date.
Are there any benefits here? There could be if you are a current high-income earner that is set to retire soon, you can leave the account alone for a few years and then start distributing the money when you are in a lower tax bracket. Timing such as this is rare, though. In general, the new 10-year rule will have you paying more taxes over the, now shortened, lifetime of the inherited IRA. This doesn’t mean that there aren’t planning opportunities. You should discuss how much to distribute each year with your financial advisor or CPA.
Inherited Roth IRAs are also subject to the new 10-year rule, but the distributions are completely tax-free. You might think that this is no big deal, but there is one major disadvantage - the tax-exempt growth window is shortened significantly. The end result of tax-free growth for 30 years is quite different than 10 years.
What about spouses?
When you inherit an IRA from your spouse, you have the option to roll over the assets into your own IRA. The new 10-year rule wouldn’t apply here. This is usually recommended. An example when it might be more beneficial to move the money into an inherited IRA is if you haven’t reached the age of 59 1/2 and you would like to start taking distributions from the account.
What Is the Difference Between the Traditional IRA and the Roth IRA?
Traditional IRAs are subject to ordinary income tax (the higher tax rate) when withdrawn. A Roth IRA is made with after-tax contributions. These dollars will not be taxed again, even on the gains accrued. Even though it isn’t always easy to know, the general idea is to contribute to a traditional IRA when you are in a high tax bracket, contribute to a Roth IRA when you are in a low tax bracket, withdraw from (or convert) your traditional IRA when you are in a low tax-bracket again. This is typically post-retirement and pre-social security (age 62-70, depending on when you choose to apply) and RMD (age 72).
Both types of IRAs will now have to be depleted after 10 years, but there is much less planning needed for an inherited Roth IRA since they are tax exempt. Just because there aren’t taxes, though, doesn’t mean you should empty it out right away. Remember, the growth is tax-free. If you do not need the income, it generally behooves you to keep it in the inherited Roth IRA until the end. Just don’t forget to do it… the 50% penalty is severe. To illustrate my point, here is an example. You inherit a $50,000 Roth IRA holding one mutual fund. In scenario A, you leave it in there and it grows to $100,000 in ten years. In scenario B, you take it out and buy the same mutual fund in your brokerage account. It’s the same fund, so it still goes to $100,000. In both scenarios, you sell at year 10.
Scenario A – $50,000 tax-exempt gain = $0 taxes due
Scenario B – $50,000 gain taxed at 20% = $10,000 taxes due (plus increases your income for the year by $50,000 which could result in additional unfavorable consequences)
Roth Conversions
A Roth conversion is a distribution from a traditional IRA into a Roth IRA. Converting your IRA into a Roth IRA can provide you with many benefits as any future distributions are tax-exempt, even on the gains attained in the account. This is a taxable event, so you should be careful on how much you decide to convert each year. Because it is considered income, this may bump you up into a higher tax bracket, increase your capital gains rate, or cause an increase in future Medicare premiums. What does this have to do with inherited IRAs? Well, if your traditional IRA has a smaller balance and your Roth IRA has a larger balance, your beneficiaries will have a smaller tax burden when they inherit the IRAs. Keep in mind, your beneficiaries will not be able to do Roth conversions with the inherited IRA. That leaves it up to you!
The SECURE Act
The Setting Every Community Up for Retirement Enhancement (SECURE) Act was established in 2019, and it eliminated the stretch IRA. It’s a bill that was created to improve the retirement process.
Although the elimination of the stretch IRA may have been a disadvantage to many, the SECURE Act provides benefits for retirement. These are some of the ways the SECURE Act has relieved the retirement crisis:
Giving retirement benefits to both full-time and part-time employees
Removing the maximum age of contribution to retirement funds that was capped at 70 ½ years
RMDs of traditional IRAs now start at age 72. Before the SECURE Act, you had to start taking RMDs the year you turned 70 ½.
Providing access to withdrawals up to $10,000 for tertiary education and paying off student loans
Smaller businesses are able to offer their employees a 401(k) with more ease
In Summary
For many, the elimination of the stretch IRA will result in higher, more concentrated taxes. If you inherit an IRA, or have inherited one in the last two years, it is best to discuss the optimal distribution path with your financial advisor or CPA.
Written by Eric Keating