Low and middle-income Americans struggling to save for retirement are depending on the U.S. Senate to pass the SECURE Act, advocates say, but one roadblock is the law’s treatment of “stretch IRAs.”
The term “stretch IRA” refers to an estate planning strategy that involves either a Roth or a traditional individual retirement account (IRA)—it is not a special type of IRA. By “stretching” the IRA, individuals can preserve their retirement account’s tax-deferred status and allow its continued use by future beneficiaries.
In his practice as an estate and trust principal at the accounting and tax advisory firm Kaufman Rossin, Scott Goldberger spends a lot of time collaborating with his clients’ retirement and wealth management advisers. He says the SECURE Act has come up quite often in recent conversations and planning sessions, as do the tax cuts passed by the previous Republican-controlled Congress.
“Every time there is change in the tax laws we spend a lot of time digesting what it means for clients,” Goldberger says. “In thinking about wealth for families and estates and trusts, the biggest change we’re dealing with in the tax overhaul is the doubling of the estate tax exemption. Practically speaking, for a lot of our clients this environment means we have to take something of a wait and see approach.”
Goldberger says he and his retirement plan adviser colleagues are following the SECURE Act closely.
“Whether a client’s tax-qualified assets are a significant or insignificant portion of their overall wealth, passage of the SECURE Act would be meaningful to them in some way,” Goldberger says. “From my perspective focusing on taxation and inheritance, the most significant development in the SECURE Act is the treatment of stretch IRAs. In short, the bill would impose a 10-year period after which the stretched IRA would have to be distributed in full to the beneficiary, rather allowing the required minimum distributions to be taken out over the beneficiary’s lifetime.”
The Problem with SECURE
Goldberger suggests this development would curb clients’ ability to use IRAs to defer income tax as long as possible, and it would also put in doubt some of the estate planning that clients may have previously done in organizing IRA trusts.
“Depending on the kinds of trust they were planning on using—it may or may not continue to be a good idea after the passage of the SECURE Act,” Goldberger warns. “Specifically, I’m talking about whether they have chosen to utilize for their beneficiaries a so-called conduit trust versus an accumulation trust.”
In very simple terms, the conduit trust is a variety of IRA trust whereby any required minimum distribution (RMD) that is paid by the retirement account to the trust is directly distributed to the beneficiary—hence the use of the term “conduit.” In Goldberger’s assessment, conduit trusts made great sense when a beneficiary had a time horizon for distributions of potentially many decades, as would be the case when a young person was named as the beneficiary under current law.
“But under SECURE, at the end of the 10-year deferral period, the entire retirement account would end up having to be distributed to the beneficiary outright,” Goldberger says. “That could be disastrous if you are trying to protect those funds for the beneficiary longer-term, especially if the beneficiary has creditor issues or divorce issues.”
In highlighting this concern, Goldberger points out that the issue can potentially be dealt with relatively easily.
“I believe this distribution issue can actually be dealt with pretty easily by using an accumulation trust as opposed to the conduit trust,” he explains. “With the accumulation trust, although the trust is getting the required minimum distributions and eventually a lump sum distribution after 10 years, the trustee is not required to then turn around and immediately pass the distributions on to the beneficiary.”
Instead, as the name indicates, the trustee can accumulate those funds within the trust for the long-term benefit of the beneficiary.
“So, even if the SECURE Act passes and we have a 10-year payout period, at the end of that period, the funds of the retirement account simply go into the trust account, where they continue to be protected for the beneficiary,” Goldberger says. “For those individuals who would have conduit trusts created under the terms of their wills or who have already created revocable trusts of this type, there is an easy fix. It is simply to amend the documents to create an accumulation trust as opposed to a conduit trust.”
Goldberger notes that other forms of “stretching” are possible beyond the use of accumulation trusts. As a prime example, he points to the linking of an IRA to “charitable remainder trusts.”
“This strategy has been around for a long time,” he says. “Simply put, the individual puts assets into the charitable remainder trust, names a beneficiary of his choosing, and then defines a payment schedule out of the trust for the beneficiary’s lifetime or for a set period of years.”
The beneficiary receives a taxable payment each year from the trust, but the wealth can continue to grow income tax-free within the trust over time. At the end of the term of years or at the end of the beneficiary’s lifetime, whatever is left in the trust is passed on to one or more charities of the choosing of the person who created the trust.
“It’s interesting to revisit this already popular strategy in the context of the SECURE Act, because, if restrictions are put on stretch IRAs and the client has an interest in charity, then they can set up one of these charitable remainder trusts that can serve as a sort of quasi-stretch IRA,” Goldberger says.
Other Concerns to Consider
Lisa Schneider, leader of the trust and estates practice at the law firm Gunster, agrees that the SECURE Act would cause some significant disruption for her clients’ estate plans.
“The SECURE Act is very important even for our very wealthy clients who have significant assets outside the retirement plan context,” Schneider says. “Many of them also have significant retirement plan assets—especially a lot of the clients who were executives. They may have a lot of wealth in their retirement plans, and the SECURE Act in my view totally changes how this group views and addresses their tax-deferred retirement plan assets.”
Schneider expects her clients would face significantly higher taxes under the inheritance regime that would be established by the SECURE Act, to the tune of a collective $16 billion more per year across the U.S.
“The stretch IRA for all intents and purposes disappears with the Act,” she says. “You have the exceptions for surviving spouses, minor children and persons with disabilities. But otherwise it’s going to have a dramatic impact from a marginal tax rate perspective. Most people would have to draw the income over a 10-year term.”
When it comes to the opportunities presented by the SECURE Act’s exceptions to the 10-year draw down, Schneider says, these may prove to be more limited than some expect.
“The problem with putting the money in trust is that under the SECURE Act as drafted, it appears that you have to look at both the initial beneficiary and the second-tier beneficiary, as well, to determine whether the structure of the trust will be excepted from the 10-year rule,” she explains. “What I mean is that, if you set up the trust initially for a spouse or a minor child, but your second tier beneficiaries are your adult children, you now don’t have that exception at every level. In my opinion it is unclear in this situation if the trust falls within the SECURE Act’s exception. This would need to be clarified in the Act itself or in the regulations that would be promulgated thereunder.”
With charitable remainder trusts, Schneider agrees this will be one option to look at.
“It’s a way of basically drawing money out longer than the 10 years, because you can spread out the benefit of the IRA over a defined period of years or a person’s lifetime,” she says. “But at the end it does go to charity, so it’s going to be a specific type of client that is interested in this.”
Individuals may also consider doing a Roth IRA conversion, Schneider suggests. The client in this situation pays the tax up front, rather than seeing the taxation occur post-mortem.
“One caveat is that you don’t want to pay the tax from within the IRA you are converting, because that defeats the whole purpose of this strategy,” she explains. “Instead, you need to have liquid assets outside the IRA to pay the taxes, and that allows the IRA to remain intact and to grow tax-free for the duration of whatever inheritance strategy you ultimately put in place. In order for the conversion to make sense in most instances, you have to have the liquidity to pay the tax. If your liquid wealth is tied up in the IRA, in business or real estate, this may not be a great approach.”