As Congressional budget negotiations over the need for increased tax revenue heat up, some of the tools that your clients have grown accustomed to including in their estate planning strategies are taking center stage once again.
The popularity of the Obama administration’s proposals to cap the value of tax-deferred retirement accounts is fading — and the focus has shifted to proposals that would eliminate the “stretch” IRA instead. With widespread support gathering behind eliminating the extended tax deferral associated with stretch IRAs, preparing clients today can prevent surprises in the future. There are a few simple steps these clients can take to minimize the fallout should the death of the stretch IRA be near.
Stretch IRAs in estate planning
Under today’s tax rules, the beneficiary of an inherited IRA can usually elect to withdraw the funds in one lump sum or receive payments over a number of years, based on his or her life expectancy. The tax benefits are substantial if the beneficiary “stretches” the withdrawals out over his or her lifetime because the value of the IRA continues to grow tax-deferred. (Or, in the case of a Roth IRA, the growth is tax-free.)
Each year, the IRS requires the beneficiary of an inherited IRA to take a required minimum distribution (RMD) from the account. Because the RMD can be based on the beneficiary’s age, rather than the original account owner’s age, the stretch IRA has become a valuable estate planning tool for transferring tax-deferred wealth to younger generations.
Proposals to kill the stretch IRA
However, these valuable estate planning tax benefits have put the stretch IRA on the Congressional chopping block today. Many argue that, because IRAs are afforded tax benefits as a part of the tax policy behind encouraging retirement income planning, they should not be entitled to the same benefits when used as wealth transfer vehicles. And, while the administration's proposal to cap tax-deferred accounts at $3 million would have deterred the use of IRAs to transfer wealth, many have criticized that method as discouraging retirement savings.
As such, proposals that would limit the stretch period for a non-spousal inherited IRA to five years are gaining widespread support. This proposal is perceived as a way to limit the IRA to its intended use while still encouraging clients to save to fund their own retirement expenses — with the added bonus that the five-year limitation period would speed up the recognition of the IRA funds for tax purposes.
Preparing your clients
With these proposals on the table, it is important your clients prepare. They may want to examine their beneficiary designations — naming any children or grandchildren as secondary beneficiaries to a spouse can allow a surviving spouse to decide whether he or she wishes to continue the IRA. (The proposals would not eliminate a spousal stretch IRA.) This also allows the spouse to decide whether the funds should pass directly to the non-spousal beneficiary despite the possible five-year limitation — perhaps a child is in college and could use the funds over a five-year period to pay for related expenses.
Further, a Roth conversion might not be attractive if the IRA is going to be subject to a complete distribution within five years of the client’s death — especially if it is possible the beneficiary will be in a lower income tax bracket than the client’s bracket at the time of conversion.
While it is far from certain that any of the administration’s proposals with regard to IRAs will become law, the growing popularity of these plans means it is important to prepare your clients with an alternate plan. If the rules do change, having a backup plan in place will allow for an orderly reshuffling of your clients’ estate plans.
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