One of my absolute favorite planning tools used to be the stretch IRA. Sadly, this option was taken away for many beneficiaries with the passage of the SECURE (Setting Every Community Up for Retirement Enhancement) Act in December 2019. With a stretch IRA, once a beneficiary inherited an IRA, instead of taking all of the money out at once and incurring a large tax bill, they were able to stretch those payments out over their lifetime. This allowed the funds to remain invested over a longer period of time and ultimately give the beneficiary potentially far more overall return than they would have gotten after paying a big tax up front. While some beneficiaries can still stretch out an inherited IRA (spouses, beneficiaries not more than 10 years younger than the original owner, and disabled beneficiaries), everyone else must now take those distributions within 10 years. A minor can actually stretch payments over life expectancy until they turn 18 and then they have to accelerate those payments over the next 10 years.
Other than accelerating income taxes to the beneficiary, why would I not want my heirs to take the funds out over 10 years? For starters, the payments received would be subject to the beneficiary’s creditors. Once they receive the payments, the money is now fair game for creditors to go after. In addition, the beneficiary might be financially irresponsible, and one to ten payments might be simply too much for them to manage properly. They could spend it all too quickly.
So what do I do if I don’t want my beneficiary to take the funds out over 10 years? One way, assuming you are in good health, is to create your own stretch by starting to direct your RMDs (required minimum distributions) that you take from your IRA each year to match premiums of a life insurance policy. There is nothing saying that some permanent life insurance policies have to have the same premium each year. You could match the premium to your RMD schedule and convert the IRA over time to a future death benefit for your heirs. Many insurance companies allow you to direct the payment of the death benefit proceeds to be in the form of an interest bearing account with an extended monthly/yearly payout. Best of all, everything except the interest is tax free! Why? Because death benefit proceeds from life insurance are not subject to income tax like the IRA is. Personally, I would go one step further and create a trust for the insurance proceeds to be payable to. This gives you maximum control of the money and doesn’t require you to leave the money with the insurance company. Once in the trust, your trustee could invest the proceeds any way they see fit. The trust could direct the payout to be structured over the life expectancy of the beneficiary, just like the old stretch IRA. You are required to take the RMD anyway, why not use the funds to replace the IRA with a tax-free benefit upon your death?
When is this strategy not a good idea? For starters, you have to be healthy enough to qualify for insurance. You may be surprised, however, to know that many people who think they can’t get insurance can easily.
If you are in fact not insurable and can’t use this strategy, you could always consider Roth IRA conversions for your IRA. Yes, you have to pay taxes on the amount converted each year but remember, we are currently in the lowest tax environment we have seen in a long time, and not too many people believe they are going lower. If we are currently $23 trillion dollars in debt, it’s hard to imagine tax rates not moving higher in the future, but I guess you never know. By paying taxes today at a known and historically low rate, you can at least make future income taken out by your beneficiaries tax free. By converting your IRA to a Roth IRA, your beneficiaries will still have to take the money out over 10 years, but again, at least it will all be tax free. For more information regarding the SECURE Act, see congress.gov/bill/116th-congress/house-bill/1994.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or email@example.com.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.