The End of the Stretch IRA
On a particular Christmas morning, I learned a valuable lesson: not everything is as I think it is. That year, I asked Santa for Gumby, a green clay figure who starred in his own television show, and Gumby’s sidekick Pokey, a talking orange clay pony. When I watched Gumby’s show as a young child, I believed that Gumby and Pokey were alive and extremely stretchy. However, after Santa dropped off my very own Gumby and Pokey, they simply were not alive and not very stretchy. My dreams of a walking, talking, ultra-stretchy Gumby and Pokey were dashed.
IRA owners are now facing a similar dilemma. With the passage of the SECURE Act, Congress concluded that the IRA “stretch” provisions were too good to be true, changing the rules that made them among the most favored generational wealth transfer tools. As Michael Hopper reviewed in the last Investment Perspectives, the SECURE Act largely eliminated the popular stretch IRA, which permitted inheriting IRA beneficiaries to stretch the withdrawals over their life expectancies.
THE NEW RULES
Under the old rules, a beneficiary could choose to take only the required minimum amount each year and enjoy a lifetime of continuing tax-deferred growth on the majority of the account balance.
Under the new rules, however, most beneficiaries must now fully withdraw the balance of the inherited IRA by the end of the 10th year after inheriting it. This new, compressed withdrawal timeline presents a possible complication.
Since distributions from traditional IRAs are fully taxable as ordinary income, beneficiaries of retirement accounts may now face substantially higher tax burdens than under the prior rules, especially if the additional income pushes them into a higher tax bracket.
When passing assets to the next generation, taxable assets – like those held in a revocable trust – are now much more tax-efficient than IRAs because of the IRS basis “step-up.” When inheriting a taxable asset, the IRS allows beneficiaries to “step-up” the basis of the inheritance to its market value as of the decedent’s date of death.
Speaking of toys, that Hasbro stock you bought at $3 in the 1980s today trades near $60. If you sell that stock, you will pay capital gains tax on $57 of profit. If you leave it to your children, however, they inherit it with $60 basis. Thus, they can sell the stock and enjoy its proceeds without any capital gains or income tax.
GIVE TO CHARITABLE ORGANIZATIONS USING IRA
So, what do we do now that the IRAs don’t work the way we thought they would?
For the charitably-inclined, IRAs should now be at the top of the list for annual charitable gifts because of the Qualifying Charitable Distribution (QCD), which is made from an IRA directly to a qualifying charity.
The IRS entirely excludes these distributions – limited to $100,000 per year starting at age 70.5 – from the donor’s income.
If you are planning to give some portion of your estate to charity, consider making the charity a beneficiary of your IRA instead of using taxable assets.
These gifting techniques can reduce the proportion of an estate that will be subject to ordinary income tax for the next generation and efficiently satisfy charitable intentions.