SECURE Act eliminates ‘stretch’ IRA, which will have implications for investors, families

Many articles, books and even PBS TV specials have touted strategies investors can use to create multi-generational legacies by passing Individual Retirement Accounts (IRAs) on for decades.

Investing in IRAs continues to be wise, but one of the most attractive benefits has been eliminated. The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which became effective Jan. 1, eliminates the “stretch” for non-spouse IRA beneficiaries.

It used to be that beneficiaries of retirement accounts could stretch required annual withdrawals over their life. That would allow the accounts more time to grow and reduce the amount that would be taxed upon withdrawal each year.

Under the SECURE Act, non-spouse beneficiaries of account holders who die after Jan. 1, 2020, generally now are required to withdraw all assets from the account within 10 years. Beneficiaries could withdraw the full balance on Day 1, the last day of the 10th year following the year of inheritance, or any variation in between.

The beneficiary can reinvest the after-tax net amount in their own brokerage account or use it to fund their own IRA if eligible. But the accelerated taxation, and possible bump into a higher tax bracket, could mean there is less after-tax money to reinvest than there might have been under prior rules.

Previously, for example, if an 85-year-old died and a 55-year-old was the beneficiary of the retirement account, the 55-year-old could make relatively small annual withdrawals over the remainder of their life to satisfy the requirements. In many cases, the beneficiary never fully depleted the account. This account then could be inherited by the next generation with tax-deferral stretched further. Now, accelerating the withdrawals will cause faster realization of income tax due. If the beneficiary is still working with their own earned income, the withdrawals from the IRA could potentially push them to a higher tax bracket.

Even more detrimental to long-term wealth and tax efficiency is the inheritance of an after-tax Roth IRA. Previously, Roth IRA beneficiaries needed to follow the same minimum distribution rules over their lifetime as pre-tax account beneficiaries, but at least there was no tax due on the withdrawals. Stretching tax-free growth as long as possible had potential for significant extra wealth creation. Now, the tax-free withdrawals are limited to 10 years. After that, any re-investment of what had been inherited via the Roth IRA will have to be done in an account where tax on growth and income is applicable.

The new 10-year rule doesn’t apply to spousal beneficiaries who can still stretch withdrawals over their lifetime. It also doesn’t apply to disabled or chronically ill beneficiaries, beneficiaries who are less than 10 years younger than the original account owner and minors (until they reach the age of majority).

The new rules create planning opportunities for both current IRA owners and beneficiaries of inherited IRAs.

These changes might cause current IRA owners to rethink who is listed as the account beneficiary(ies). This is especially true if the beneficiary is currently a trust. Trusts come with their own instructions for how money is to be distributed and can be taxed differently than individuals. Some trusts meant to receive pre-tax assets may need to be revised to reflect the new tax law.

For families with the means and flexibility to practice proactive, multi-generational planning, these changes could increase Roth IRA conversions. With this strategy, owners of pre-tax IRA assets can move, or “convert,” that money to a Roth IRA if it appears to be more advantageous to pay a known (relatively low) tax today than a possible higher rate in the future when withdrawing from the pre-tax IRA under the accelerated 10-year rule. Roth conversions might make sense in small increments over a series of years to best manage the amount of tax due.

Inherited IRA beneficiaries who have some ability to manage their taxable income and relevant tax brackets from year-to-year could find it helpful to withdraw more from the inherited IRA in years when they have relatively low income. Beneficiaries who are still working, but expect to retire within the 10-year window, should consider deferring all withdrawals until after they retire when their taxable income is lower.

The SECURE Act has carve-outs that either don’t apply or have different time lines. Government retirement accounts like 403(b), 457 deferred compensation or the Thrift Savings Plan are not subject to the 10-year rule until Jan. 1, 2022. Also, exempt from the 10-year withdrawal rule are annuities that contractually stretch payments over life.

This is one more example of how the tax code comes with intricacies and caveats that don’t apply evenly to everyone. Consult a tax professional before you execute any strategies specific to your situation.