A lump of coal, and the Stretch is gone

Well, they did it to you. Right before Christmas, too. Your Congress sent you a nice Christmas stocking, but inside was a nasty lump of coal.

They eliminated the “Stretch IRA”.

I guess I had better back up and explain. A stretch IRA is a device which estate planners have been using for many years, to minimize the income tax bite for your heirs. And now, except in limited situations, we can’t use it anymore. In fact, many people now desperately need to change their plans to avoid a huge income tax bomb for the heirs.

Let me back up further. Income taxes do not apply to most things you inherit. If my rich uncle dies and leaves me a piece of real estate worth $400,000, I do not have to pay income taxes on that $400,000. If he is rich enough (over $11.6 million) I might have to pay estate tax (also known as “death tax”), but assuming he is below that exemption amount, I get the property tax-free.

But if the same uncle dies and leaves me an IRA worth $400,000, I have to pay income tax on that because it was “tax-deferred”. How much tax I have to pay depends on how I handle things after he’s gone.

(In this article I am going to use the term IRA, but I actually mean any account which is tax-deferred, such as a SEP, Simple IRA, 401k, 403b, TSP, SBS, or deferred comp. But not Roths, they’re different.)

Up until now, the smart thing for me to do would have been to roll that into a “beneficiary IRA”. Then I would have only had to take out a very small amount each year, and pay taxes on that withdrawal. I could take out more in any given year if I wanted to, I just had to pay the tax. The advantage of rolling it like that is that it spreads out the withdrawals for income tax purposes. If I cash that IRA out, I have $400,000 in ordinary income in one year, which is going to push me into a very high tax bracket. If I made, say, $50,000 a year from my own work, I would be paying taxes based on that, plus the IRA. Imagine what somebody pays in taxes if they make $450,000 every year, and that’s the tax rate I’d be paying. It’s a lot, in fact it almost certainly puts me into at least a 35% tax bracket, and maybe even higher. In fact, if I get up that high in my income, I actually lose a lot of other tax deductions that I could normally take, so in reality I’m now also paying more tax on that $50,000 I earned on my own.

If I stretch the withdrawals out over my lifetime, I am in a much lower tax bracket each year, than I would be if I cash out the whole thing. I still have to pay income taxes, but I don’t get whacked with a 35% tax rate.

That is what estate planners call a “stretch IRA”. And that’s what they just took away.

The stretch IRA still exists in a few specific situations. A surviving spouse can still roll that money into a stretch IRA. So can a disabled beneficiary (although they have to be disabled to the extent that they are not able to earn money at all), or someone who is chronically ill. If you leave that IRA to a minor child, it can be stretched, but only until they turn 18, and then the 10 year clock starts. And this is kind of an odd one, but if you leave it to someone who is less than 10 years younger than you (for instance, a younger sibling or significant other) they can still stretch it.

Everyone else has to take it out within 10 years. They can stretch the withdrawals that far, but no more than that.

Congress tried to pretty this up for PR purposes. They started the bill with some changes that actually help people save more in these types of accounts. For instance, on an IRA-type account you earn yourself, you can now wait until you are 72, instead of 70 ½ under the old law, to start taking money out of the account. And you can continue contributing to the IRA past the age when you would have previously had to stop. I’m not sure how many people will really want to do that, especially since, if there is money left in the account when they die, their heirs are now going to be paying more taxes on that money. But the Congress hid the increase in the taxes the inheritors pay, at the very end of the bill under “revenue provisions”. I would have titled it “by the way, it’ll cost ya”.

For most people, this is a tax increase, but not a huge one. To use my earlier example, if I can only stretch that $400,000 inherited IRA over 10 years, it adds $40,000 to my income for tax purposes each year. If I am making $50,000 each year from my own efforts, I would now have to pay taxes on $90,000.

Where it causes a significant problem, is when the beneficiary is not responsible enough to stretch out the IRA. I can take out that money gradually over 10 years, but if I am really irresponsible (or have a substance abuse problem), I might be tempted to take the money out faster than that. If my uncle wants to make sure I don’t do that, he has the option of setting up a “conduit trust” and feeding the money into the trust on his death. That way instead of me deciding whether to take more than the required minimum each year, a trustee (someone my uncle has chosen for that duty) makes that decision.

And my uncle can still set up a conduit trust under the new law, the money just has to be taken out within 10 years. That is unfortunate if I have major issues, but it is what we are left with.

Here’s the real kicker: conduit trusts which were set up before this new act was passed, may be ticking time bombs. Many of them do not allow any discretion for the trustee to pay more than the required minimum distribution each year. Let us suppose that my uncle wants to make sure that the money he is leaving me through his IRA is spread out throughout my lifetime. He may have written a rule into the conduit trust that the trustee does not have the discretion to pay more than the required minimum distribution each year. That would have been a smart way to make sure I didn’t have the opportunity to blow the money.

But under the new law, there is no required minimum distribution, until the 10th year. For most beneficiaries, the only requirement for distributions is that the trustee must pay it all out within 10 years. But that means the required minimum distributions would be zero in the first year, zero in the second year, and so forth all the way until the 10th year, when all of a sudden the entire account has to be pulled out and tax paid.

And that means that the entire $400,000 IRA ends up being taxable income in one year. That is to say, in year ten.

So if you have a conduit trust in your estate plan, you need to get in touch with your planner right away to see if it needs to be changed. If you don’t, but you have a decent amount of money in tax-deferred accounts, you should talk to whoever does your estate planning, because the increase in taxes for your heirs may mean that you want to consider doing something different.

Thanks, Congress! And Merry Christmas to y’all right back!

Kenneth Kirk is an Anchorage estate planning lawyer. Nothing in this article should be taken as legal advice for a specific situation; for specific advice you should consult a professional who can take all the facts into account.

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