Earlier this year, the Senate Committee on Finance voted to kill a strategy used to greatly enhance the value of an Individual Retirement Account (IRA). Permitted since 1987, the so-called “Stretch IRA” plan allows an IRA beneficiary to take distributions from an inherited IRA out over his or her lifetime, allowing the IRA account to grow tax-deferred and stretching the tax bill over many years. Many IRA owners have named children and even grandchildren as beneficiaries, making the strategy a useful tool to leverage assets to later generations.
This is not the first time the strategy has caught the eye of legislators, probably because it is projected the change will generate $5.5 billion in additional revenue over 10 years, but the Republican-led Committee, which includes 14 Republicans, voted unanimously, leading many to believe that, this time, action will be taken.
The change affects only non-spousal beneficiaries, who would have to pay taxes on an inherited IRA within five years of the owner’s death, with the first $450,000 excluded. However, the balance would be taxed at the beneficiary’s marginal rate. Surviving spouses could still stretch the taxes out over their lifespan or even roll the inherited amount into their own retirement plan.
With over $25 trillion in untaxed retirement accounts and $7.8 trillion in IRAs alone, (1) it is no wonder the government is looking to gather its tax money as soon as possible.
If the law is enacted, some financial advisers suggest converting to a Roth IRA. However, under the proposal, a Roth IRA left to a non-spousal beneficiary would also have to be distributed within five years, just like a traditional IRA. While the eventual Roth IRA distributions would be tax-free to the beneficiary, the conversion would be taxable to the IRA holder.
Another option that might provide more flexibility and greater leverage would be the use of an Irrevocable Life Insurance Trust (ILIT). As with the Roth IRA strategy, the IRA distributions to fund the plan would be taxable, but the life insurance death benefit could be passed on free of federal and state income and estate taxes.
According to Ed Slott, a noted IRA authority, life insurance makes sense. In an article just published in a financial planning magazine, he suggests, “Forget the stretch IRA. You’re better off taking the money out now, paying the taxes, and putting that money into a life insurance policy that will be tax-free when it’s cashed in. You could easily take a $300,000 IRA and turn it into a $1 million life insurance policy.” (2)
The next few years will provide challenges and opportunities for trust advisors to help clients rethink their financial plans and goals. ILITs will remain a viable tool for leveraging assets.
- From information provided by the Investment Company Institute, Washington, D.C.
- Stretch IRA: Are Its Days Numbered?, Financial Advisor Magazine (www.fa-mag.com), December 27, 2016
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