The New Stretch IRA – The White Coat Investor – Investing & Personal Finance for Doctors

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For years, and especially the last few months, there have been numerous headlines trumpeting “The Death of the Stretch IRA!” Take a look:

Ed Slott in InvestmentNews

 

James Lange in Forbes:

Lewis Braham in Barrons:

Even CNBC got in on the act:

There’s only one problem. The Stretch IRA didn’t die. It just changed. In one respect, it got better. In another respect, it got worse. (Or if you’re Congress, the IRS, or anyone who thinks government should have more money to do more stuff, in one respect it got worse and in another respect, it got better.) Let me explain.

Change # 1 No RMDs Required for Inherited IRAs

The first change, which everyone seems to gloss over, is the elimination of a requirement to take an RMD from the inherited IRA every year. You don’t have to take a single withdrawal from that sucker until year 10. That is a substantial advantage.

Consider someone who leaves their Roth IRA to their 80-year-old little sister. That woman would be required to withdraw 5.3% of that IRA this year, 5.6% next year, and so on until age 90, when she would be required to take out 8.8%. How much of a difference would that make for her to not have to take anything out until year 10?

Well, let’s assume it’s a $100,000 Roth IRA growing at a miraculously even 8% a year (in truth, variable returns would make this effect worse). If she didn’t take anything out for 10 years, it would be worth $215,893. With those withdrawals, it would only be worth $108,021, half as much!

Now, to be fair, you would have taken $77,301 out of the Roth IRA, and if you had invested that in some reasonable way (let’s say it earns 6% after-tax) it would have grown to $99,043, for a total of $207,065. So you end up with $8,828 (4.3%) more. That’s a nice little kicker for tax-free growth. But you also eliminate the hassle of having to remember to take the RMDs, any possible penalty for forgetting to do so (50% of the amount you should have taken), and the costs of reinvesting the money.

This is a nice benefit. This is the New Stretch IRA. If your heir will just sit on that IRA, it is likely to at least double in size over the next decade. It’s not the same stretch IRA we used to have, but it still beats no stretch IRA at all.

Change # 2 You Have To Withdraw All the Money By Year 10

Here is the Stretch IRA change all the headlines above are bemoaning. Instead of potentially being able to leave your IRA to your great grandkid and having them stretch it over the next 80 years, that kiddo has to withdraw all the money in year 10. I just find it hilarious that people are whining about this. It truly demonstrates just how much the human psyche hates to lose something, even if it is something almost nobody actually ever had. Most IRAs have never even been inherited yet because most people who started them haven’t died. Traditional IRAs have only been around since 1974, 401(k)s didn’t exist before 1978, Roth IRAs didn’t show up until 1997, and Roth 401(k)s didn’t start until 2006. 401(k)s became popular in the early 1980s, but the employee contribution didn’t even hit $10K until 1998, just in time for everyone to lose half their money anyway in the tech meltdown.

So points # 1 and # 2 are that very few people have ever actually inherited an IRA and that IRA was likely pretty small anyway. But point # 3 is the real killer: Most heirs were never going to maximally stretch an IRA anyway. I mean, people are people. You give somebody $50K, $100K, even $500K or a million and what are they going to do with it? You really think they’re only going to take out 1, 2, 3% a year? I’ve got a bridge to sell you. You might think your kids are all going to be high earners and financial whizzes, but let’s not kid ourselves. They’re going to buy boats, drive Teslas, buy a bigger house than they could otherwise afford, and send their kids to private preschools and colleges.

I think they’d be doing pretty good if that inherited IRA lasted longer than 10 years anyway! And that’s assuming they can invest their way out of a paper bag. Maybe they panic in the first bear market they see and sell low, losing half its value before spending the rest on a brand new Tesla Z with incrediludicrous mode and 6 wheel drive.

Point # 4? You probably weren’t going to leave that thing to your great grandkid. Probably not even your grandkid. You were probably going to leave it to your kid, who is maybe 25 years younger than you. If you die at 95 they’re already 70, their RMDs will start at 3.6%, and at most they would be able to stretch it 20 or 30 years.

Enough ranting though. Only being able to stretch an IRA for one decade instead of 2-7 decades truly is a loss for those precious few who built a huge IRA, didn’t spend it, and left it to a young, financially savvy heir. But wait, there are exceptions to this rule.

The Exceptions

Of course, this new change isn’t universal. There are some people who can still stretch an IRA indefinitely. These “Eligible Designated Beneficiaries” include:

• Your spouse
• Any disabled heir
• Individuals less than 10 years younger than the deceased
• Minors (but only until they turn 18).

You may see some lists that include “chronically ill” as a definition, but the definition of chronic illness is basically the same as being disabled so I didn’t include it as a separate category.

What You Should Do Differently Now

So here’s where the rubber meets the road. You know the law changed. You know what the changes are. But what should you do about it?

# 1 Designate Eligible Beneficiaries

You will likely have lots of heirs, why not preferentially leave the IRAs and Roth IRAs to designated beneficiaries? I mean, most will likely leave it to their spouse (who will probably still usually roll it into their own IRA rather than taking it as an inherited IRA anyway), but when the second spouse dies, then you’ve got some decision making to do. You can still leave it to a great grandkid. They might get almost 2 decades of stretching out of it. You can also leave it to your sibling or other elderly person. If you have one disabled kid and one healthy one, why not leave the IRA to the disabled one and the taxable account to the healthy one? The exceptions are definitely something to be aware of when doing your estate planning and designated beneficiaries.

# 2 Fix Your Trust

If you designated a trust as the beneficiary of your IRA, you probably need to go see your estate planning attorney again. If you have a conduit trust as the IRA beneficiary that specifies that only the RMDs are distributed each year, that heir isn’t going to get squat for 9 years and then is going to get a huge bolus in year 10. Probably not what you were hoping for. If you have a discretionary trust, all that money is going to be sitting in there after 10 years getting taxed at the high trust rates. The bottom line is that you probably want to change the directions for the trustee to follow so that your money doesn’t end up with the IRS instead of your heir.

# 3 Beg For the Roth IRA

If your parents are passing out their IRAs, ask if you can be the one who gets the Roth IRA. Not only are you likely to get more after-tax money (since many of your siblings may not recognize that a traditional IRA isn’t worth as much as a Roth IRA), but you can just leave it in there for a decade and then take it all out at once. Much easier.

# 4 Plan Your Withdrawals Carefully

If you do end up inheriting a traditional IRA, all is not lost. You have 10 years to get that money out. Obviously you want to leave it in there as long as possible to facilitate tax-protected growth (and asset protection), but you also don’t want to pay any more taxes than you otherwise would have to.

1. If you’re in the top tax bracket and always will be, well, just leave it there for all 10 years and take it out at the end.
2. If it’s a tiny IRA and won’t even get you near the next tax bracket, again, leave it there for all 10 years.
3. If it is a large IRA, then you need to plan a little bit more carefully. Let’s say you’re married filing jointly with a taxable income of $250K and its’ a $200K IRA, likely to be $400K in 10 years. You are currently in the 24% tax bracket and can take an additional $77K a year in income without having to pay 32% on it. $400,000/77,000 = about 5 years. So you should probably start taking withdrawals up to the top of the 24% tax bracket after about 5 years. Obviously, if your income or tax rates change, you may have to adjust the plan.
4. If it is a really large IRA, you may need a more extreme plan. Maybe you take a year sabbatical and pull $300K from the IRA all at once. Or maybe you plan your retirement date around the last couple of years of the 10 year period and spend the inherited IRA first.

# 5 Consider Doing More Roth Conversions

If you expect your heir to be in a high tax bracket/peak earnings years for all ten years when they can withdraw from your IRA, consider doing more Roth conversions so that they can stretch it out for all 10 years.

The Stretch IRA isn’t gone, but is different (at least for most heirs). It’s important to understand how the New Stretch IRA works and take advantage of it.

What do you think? What changes will you make in your financial or estate plan as a result of these changes? Do you have an inherited IRA? How long have you been stretching it? Comment below!

 

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