Compliance January 13, 2020

Stretch IRA’s Disappearance Demands Trust Adjustments

“There is a lot of work that some clients should do right away—it’s actually imperative to address these issues in a timely fashion,” warns Jamie Hopkins at Carson Group.
Reported by

Art by Julie Benbassat


Among the many sources to discuss the passage of the Setting Every Community Up for Retirement Enhancement Act, or “SECURE Act,” with PLANADVISER was Jamie Hopkins, director of retirement research at Carson Group.

Like the other commentators, Hopkins agreed that the SECURE Act is an important development for the retirement plan industry, recalling the significance of the Pension Protection Act of 2006, as well as the more recent Tax Cuts and Jobs Act, which also had a substantial impact on retirement planning. Where his perspective differs is in what he foresees as the key short-term takeaways and action points of the new law—downplaying the likely impact of the law’s open multiple employer plan (MEP) provisions and instead emphasizing the disappearance of the “stretched” individual retirement accounts (IRAs).

For more stories like this, sign up for the PLANADVISERdash daily newsletter.

“There are definitely people out there who are not happy to see the stretch IRA go away, but I am actually a big fan of getting rid of it,” Hopkins says. “I’ve been on the record saying that for the better part of 10 years. The Supreme Court has established that inherited accounts are not the same thing as retirement accounts. For that reason I am not of the belief that it makes sense to give extended tax benefits out for a child or grandchild who inherited assets that last all the way through their own retirement.”

Hopkins expects the new rules for inherited IRAs will have significant tax consequences for some wealthier individuals that advisers work with. Indeed, this is suggested by the Congressional Budget Office’s analysis of the SECURE Act.

“There are a lot of people who are unhappy about this and it’s something that advisers should be aware of and ready to work on,” Hopkins says. “There is a lot of work that some clients should do right away—it’s actually imperative to address these issues in a timely fashion. One big topic to address is peoples’ trust arrangements, especially when conduit/pass through trusts have been set up to be the beneficiaries of IRAs and to pay out only required minimum distributions [RMDs] to a spouse or heir.”

Such conduit/pass through trusts were designed to take advantage of the “stretch IRA” provisions that have—up until the passage of the SECURE Act—allowed IRAs to be used as incredibly tax efficient inheritance vehicles. According to Hopkins, such trusts should be reconsidered as soon as possible, because of certain language in the SECURE Act which could inadvertently lead to major negative tax and illiquidity consequences.

Hopkin’s concern is couched in his reading of “TITLE IV—REVENUE PROVISIONS,” and particularly “SECTION 401. MODIFICATION OF REQUIRED DISTRIBUTION RULES FOR DESIGNATED BENEFICIARIES.”

“The way the SECURE Act was drafted, it says the assets in an inherited IRA must be distributed within 10 years,” Hopkins explains. “However, on my reading, it does not actually say that there are any required minimum distributions for years one through nine. Depending on how this new language is interpreted, beneficiaries might not have access to the inherited IRA money, potentially, until year 10. I was talking to a trust company back in the fall, and they said they are worried about this issue. It’s more than a technical nuance.”

This change is potentially problematic for certain clients because many conduit/pass through trusts have been structured to protect the assets from creditors, and as part of that strategy, they only give the spouse or heir access to annual required minimum distributions, as determined by the current tax laws. So if the SEUCRE Act is not totally clear about whether RMDs are due for the first nine years after someone inherits an IRA, this could lead to confusion and less-than-optimal outcomes. 

“You could imagine a case where someone has $1 million in an inherited IRA,” Hopkins says. “They might not have access to it in a pass-through trust until year 10, when the $1 million would be kicked out in a single taxable event. That’s a disaster from a tax planning perspective. Many, many trusts have been drafted in the last 30 years that could be subject to this issue.”

While it’s not necessarily the case that the SECURE Act’s language will be interpreted this way in practice, it still makes a lot of sense for clients to go ahead and update their trusts to reflect the new framework. Notably, the revenue provision section states that “except as provided in this subsection, the amendments made by this section shall apply to distributions with respect to employees who die after December 31, 2019.”

“Even before this change, a lot of people wrongly assumed their trust arrangements are fine, even though they haven’t been revisited in many years,” Hopkins warns.

Inheritance Planning Sans Stretch

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 previously told PLANADVISER the SECURE Act has come up quite often in client conversations and planning sessions, as do the tax cuts passed by the previous Republican-controlled Congress.

Agreeing with Hopkins, Goldberger says many wealthy people aren’t happy to see the stretch IRA disappear with the SECURE Act. But, Goldberger notes, other inheritance pathways already exist that are also attractive from a tax mitigation standpoint.

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,” Goldberger 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.

Individuals may also consider doing a Roth IRA conversion, suggests Lisa Schneider, leader of the trust and estates practice at the law firm Gunster. 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.”

The Markets January 9, 2020

Keeping Defaulted Participants on the Right Path

Roughly 80% of participants initially accept target-date funds when they are offered as the default investment, although acceptance declines to approximately 70% after five years of participation.
Reported by

Art by James Yang


Morningstar has published a detailed new white paper titled “Made to Stick: The Drivers of Default Investment Acceptance in Defined Contribution Plans.”

Written by David Blanchett, head of retirement research for Morningstar Investment Management, and Daniel Bruns, vice president, product strategy, Morningstar Investment Management, the paper analyzes the survey responses of some 46,439 participants across 175 plans using 18 different target-date series.

Never miss a story — sign up for PLANADVISER newsletters to keep up on the latest retirement plan adviser news.

According to the analysis, approximately 80% of participants initially accept target-date funds (TDFs) when they are offered as the default investment, although acceptance declines to approximately 70% after five years of participation in the DC plan. Seeking to better understand this pattern, the white paper explores four key attributes associated with a plan’s default investment to gauge their impact on “default stickiness.” These are the expense ratio, the size of the sponsoring target-date fund company (which is assumed to be a proxy for general brand awareness), the relative risk of the respective target-date vintage (i.e., equity allocation versus all other funds in the same Morningstar Category), and relative performance of the target-date fund.

“While we find that certain target-date attributes do have a relation to default investment acceptance, they tend to be less important than certain demographic variables, such as income and balance,” Blanchett tells PLANADVISER. In other words, examining the characteristics of the plan population will tell one much more about the likely use of default target-date fund investments versus examining the specific characteristics of the default fund itself.

Blanchett notes the findings do show that default investment acceptance increases marginally for target-date funds with lower expense ratios, lower levels of equity risk, and higher relative performance, with expense ratio having the largest effect among the three.  

According to the white paper, the average expense ratios across the 19 series was 46 bps and the plan-weighted average was 31 bps. The plan-weighted average is lower than the overall average given the relative low cost of series such as the Vanguard target-date series, the paper explains, which had an average 14 bps expense ratio. T. Rowe Price was the most expensive widely used target-date series, with an average expense ratio of 67 bps.

“Target-date funds are professionally managed multi-asset portfolios that are likely to result in better investment outcomes than if an average participant was to self-direct his or her own portfolio,” Blanchett says. “The goal should be to get as many participants in the default investment as possible, and to keep them there, so it’s really important to understand who is choosing to use them and who is not.”

In terms of practical takeaways, Blanchett says that participant age has an “interesting effect” on default acceptance rates.

“Older people are less likely to accept a default investment, but it’s not simply because they are older,” he explains. “Almost the entire effect comes about because older participants tend to have higher balances and higher incomes than those who are younger. When you control for age, income and balance, default acceptance is pretty much the same for all ages.”

In this sense, Blanchett says, the research really shows that it’s important to understand the underlying drivers of behavior.

“If you just think, oh, default acceptance just diminishes with age, you’re missing the deeper point,” he warns. “If you have a plan with an older population that has lower income and lower balances, the patterns of behavior could be totally different than a plan where you have mainly high-balance, high-income older employees.”

The lesson here is that plan sponsors must carefully analyze their participant demographics in making decisions about default investments, Blanchett says, adding that the paper’s conclusions also make him think about the importance of re-enrollment. This may be the best tool plans have to keep people invested in the default fund. 

“Re-enrollment is a powerful tool for keeping more people in professionally managed default investments,” Blanchett says. “It’s always been strange to me that we have people annually reconsider their health care choices, but we have no similar mechanism on the retirement planning side. I think these findings underscore the importance of regular re-enrollments as a way to keep more people in high-quality, professionally managed investment portfolios.”

TDFs Drive Different Investing Behaviors

The TIAA Institute published a related research paper in 2019, dubbed “The effect of default target-date funds on retirement savings allocations.” In short, the paper finds that, while the use of one TDF versus another TDF does not strongly impact default acceptance, participants are more likely to exit other types of default investments, such as money market funds.

According to the TIAA Institute, prior to the adoption of target-date defaults, most retirement plans used money market fund defaults, and participants who joined plans with a money market default largely switched away from the default fund.

“[After leaving the default,] these participants had substantial variation in the equity exposure for their contributions and … allocated contributions to a median of three funds,” the TIAA Institute analysis says. “Women had less equity exposure than men and contributed to more funds, and participants contributed to more funds if the plan offered more funds.”

The TIAA Institute analysis shows those who joined a plan with target-date defaults behaved differently, with more than two-thirds investing in a single fund, with both sexes holding more in equity. The analysis further shows women in plans with a TDF default invest in fewer funds and carry the same average equity exposure as men, and with the size effect of the menu becoming insignificant.

“Our results for target-date funds are partially in accord with the existing literature on defaults,” the analysis concludes. “With target-date defaults, roughly two-thirds of new participants contribute only to a single fund, and they therefore allocate contributions in accordance with the equity percentage of that fund. Those who joined plans prior to the adoption of target-date defaults, when money market funds were the most common default, hold more funds and there is more cross-participant variation in equity contributions, with average equity contributions significantly below those of target date default participants.”

The TIAA Institute explains there are gender effects at play here, with women contributing significantly more to equity after target-date defaults became the norm than before. In fact, male-female disparities in equity percentage have largely vanished with target-date defaults. Also important to note, according to the analysis, is that the availability of target-date funds within a plan seems less important than whether these funds are the default investment. This is evident in the relatively sparse use of target-date funds in 2012 by participants who joined plans before they were a default, TIAA Institute says.

«