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Say Goodbye to the Stretch IRA Under the SECURE Act

IRAs and 401(k) plans are popular investment vehicles because of the tax benefits. Assets deposited into these accounts are only subject to income tax when they are withdrawn. The IRS sets a certain age at which withdrawals must start (currently 72) and provides for annual “required minimum distributions (RMDs).” These RMDs are calculated based on the life expectancy of the account holder. This allows the money to continue to grow tax free for an extended period of time. Previous tax laws allowed beneficiaries of 401(k)/IRA accounts to continue to defer paying taxes after the account holder’s death. However, the new SECURE Act has made some significant changes to these rules.


Various estate planning tactics have been used over the years to maximize tax deferral when a 401(k)/IRA is inherited. A popular planning device is known as the “stretch IRA.” Prior to 2020, if an individual inherited an IRA, the “required minimum distribution” was recalculated based on the life expectancy of the beneficiary. Accordingly, by selecting a young beneficiary, the original account holder could enable the income tax deferral to be extended, or “stretched,” for decades.


Effective January 1, 2020, a newly enacted law known as the SECURE Act changed the tax treatment of inherited 401(k)/IRAs, severely limiting the ability to “stretch” an IRA. The law provides that in most situations, all of the funds in an inherited 401(k)/IRA must be withdrawn within 10 years of when they are inherited. No RMDs are required, so a beneficiary can wait until year 10 to withdraw the full amount. However, the maximum time that income tax can be deferred is 10 years.


There are some exceptions, which extend this period. The first is that a spouse and disabled beneficiary can continue to withdraw over their own life expectancy. Minor children (but not grandchildren) can defer taxes until 10 years after they turn 18. Everyone else is subject to the 10-year rule, which includes trusts that are designated as beneficiaries of an IRA. They no longer enjoy the same tax deferral they had under prior law.


Before 2020, certain trust structures could be used to obtain the advantages of trust while also being a “qualified beneficiary” that could receive the benefit of the stretch period. Essentially, a properly drafted conduit or accumulation trust could be designated as the beneficiary of an IRA, but defer taxes based on the life expectancy of the individual who was the beneficiary of the trust.


Under the SECURE Act, a “conduit trust” can only defer taxes for 10 years. With a conduit trust, the trustee withdraws the RMD and immediately passes it to the beneficiary. Because tax deferral is now limited to 10 years, there are much fewer benefits to creating such a trust.


Similarly, “accumulation trusts,” are also limited to 10 years. However, now they may also be subject to high taxes during that 10 year period. An accumulation of trust allows the trustee to retain the RMD in the trust rather than pay it to the beneficiary. However, the trust will have to pay taxes on the RMD at the trust income tax rate which is much higher than the individual income tax rate.


The benefits of setting up either of these trusts may outweigh the new restrictions. However, holders of 401(k)/IRA accounts should meet with an experienced estate planning attorney to avoid potentially unanticipated consequences caused by the changes in the law.


Contact us to discuss how we can help you with your estate planning.

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