Whether you’ve amassed a small fortune during your working career or have a five-figure IRA you’d like to pass on, one popular way to do so has been the stretch IRA. This strategy will allow you to pass your IRA onto your heirs without many of the limitations that normally apply to these accounts. However, the SECURE Act, which was signed into law in 2019, largely eliminated this once-popular strategy. As a result, those looking to preserve their wealth through their heirs must turn to alternatives. Here’s what you need to know.
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What Is a Stretch IRA?
The stretch IRA is a now-defunct strategy that allowed non-spouse beneficiaries to take advantage of longer periods of tax-deferred (or tax-free) growth. Normally, those with a traditional IRA must begin taking required minimum distributions (RMDs) at a certain age. The age was increased to 72 with the passing of the SECURE Act. But with a stretch IRA, a non-spouse beneficiary could “stretch” distributions until the end of their life expectancy and not the life expectancy of the original account holder.
For a traditional IRA, that meant a longer period of tax-deferred growth. And for a Roth IRA, the account would continue to grow tax-free until funds were withdrawn.
Because this strategy allowed beneficiaries to stretch distributions out for the remainder of their lifetimes, those distributions were often much smaller, and the IRA could grow many years longer. With a traditional stretch IRA, smaller distributions also meant less due in taxes, potentially putting beneficiaries in a lower tax bracket.
While the stretch IRA allowed many taxpayers to minimize taxes and create generational wealth, the SECURE Act mandated beneficiaries to distribute the entire balance of the IRA within 10 years of the original account owner’s death. This new provision applies to all IRAs where the owner dies after Dec. 31, 2019.
While the 10-year rule will apply to inherited IRAs in many cases, there are still some ways to avoid it. For one, it only applies to non-spouse beneficiaries, meaning spouses are not subject to the new rule. There are also exceptions for children who are minors, beneficiaries who are disabled or chronically ill, or beneficiaries who are not more than 10 years younger than the original account holder. The exception for minors only applies as long as the child is younger than 18. Still, that could add several years of tax-deferred or tax-free growth for the account.
5 Stretch IRA Alternatives
Because inherited IRAs must now be distributed within 10 years, you might be looking for alternative ways to preserve your wealth and pass it on to beneficiaries. Here are five stretch IRA alternatives:
Roth conversions. If you have a traditional IRA, one option is to convert it to a Roth IRA before passing it to your beneficiaries. The benefit of this approach is that your beneficiaries won’t get stuck with paying taxes on the money as it is distributed. This may also lower their taxable income.
But this approach also has its downsides. The biggest one is that you will have to pay taxes on the entire amount that is converted and that amount will be taxed as income. Plus, your beneficiary will still have to draw down the entire account within 10 years of inheriting it.
Life insurance. With this approach, you take distributions from your IRA and use them to pay premiums on a life insurance policy. The funds in the life insurance policy can continue to grow tax-free and pay a lump sum to your beneficiaries when you die.
If you have a traditional IRA, be sure to wait until age 59 ½ to avoid an early withdrawal penalty. You will also have to pay income tax on the distributions from the account. But your beneficiaries won’t have to pay taxes on that amount in most cases, and they can invest the money in their own IRA so it continues to grow.
Irrevocable trusts. You can also use a life insurance policy to fund an irrevocable trust. The approach here is similar – the original account holder uses distributions from the IRA to make gifts to the trust. Upon the account holder’s death, the policy will pay a death benefit to its beneficiaries, providing a regular income stream. The biggest benefit of this approach is that irrevocable trusts are not subject to estate taxes; hence, this is a good idea if you have a sizable estate.
Charitable remainder trusts. Under this strategy, the IRA owner sets up a charitable trust and funds it using the IRA, similar to the strategies outlined previously. When the IRA owner dies, funds are paid to the trust and then the trust’s beneficiaries. While a certain portion must go to charity with this strategy, it does allow beneficiaries to avoid the 10-year rule.
Now that the stretch IRA will be phased out, those who want to preserve their wealth through their heirs must consider the alternatives. While none are a perfect replacement, many of them may allow your beneficiaries to get around the dreaded 10-year rule. The one exception is converting your IRA to Roth. In this case, your beneficiary will still have to draw the account down entirely within 10 years.
Estate Planning Tips
- A financial advisor could help you put an estate plan into action. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Learn more about wealth transfer planning as you think about passing your wealth on to your beneficiaries.
- Use SmartAsset’s retirement planning guide for more tools and tips on planning your retirement. These tools include the 401(k) calculator and the retirement tax friendliness calculator.
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