By Jamie Hopkins, Director of Retirement Research
Get ready for a new normal.
With the SECURE Act comes the demise of the stretch strategy – and that could cost your loved ones if you don’t revisit your retirement income plan.
It’s long been common practice to stretch IRA and 401(k) distributions over the life of the beneficiary. A smart strategy for two reasons:
- It allows the tax-advantaged nature of retirement accounts to continue for years, even decades. Investments continue to grow tax-deferred inside of the IRA or 401(k).
- Spreading out the taxable distributions can help reduce the tax burden.
But when the SECURE Act goes into effect – expected on Jan. 1, 2020 – beneficiaries will have to fully distribute taxable accounts within 10 years of the account holder’s death. That could push your loved ones into a higher tax bracket.
The stretch strategy’s undoing is no surprise: It’s been proposed for years in government, because it would generate generous tax revenue. The SECURE Act is expected to raise roughly $16.4 billion in revenue over the next 10 years. Almost all of it – $15.7 billion of the $16.4 billion – will come from the elimination of the stretch option.
Is there a viable alternative to the soon-defunct stretch strategy?
We can’t fully replicate the tax-deferred nature of the IRA or 401(k) on inherited accounts. But charitable remainder trusts and insurance products could provide similar benefits. People should focus on more tax-efficient strategies as part of their retirement and estate planning.
Bracket-bumping Roth conversions is the strategy primed to give beneficiaries a boost in the SECURE Act era.
Roth IRAs will still be subject to the 10-year distribution period under the SECURE Act, but distributions from the Roth won’t impact the beneficiary’s taxable income.
Roth conversions require the account owners to plan in advance. If done correctly, they can cancel out the taxes that come with a shortened distribution period.
Let’s look at a quick example. You leave $1,000,000 in an IRA to your child – a 40-year-old, single professional who earns $120,000 a year. Under previous rules, they could stretch out distributions over 44 years. The first-year distribution would be about $22,727.27. This wouldn’t push them into a higher tax bracket.
Under the SECURE Act, your child will have to distribute the account over 10 years. They decide to spread it out evenly, taking out $100,000 in the first year. This pushes them up to $220,000 of income with roughly $40,000 of the distribution into the 32% tax bracket and roughly $16,000 of the distribution into the 35% tax bracket. This significantly increases the taxes they’d pay on the IRA.
Instead of leaving the money in an IRA, you can start doing strategic Roth conversions to alleviate that tax burden before you die.
Let’s say one parent was in the 24% tax bracket with $100,000 of income. They could start doing Roth conversions early in retirement to take advantage of their full tax bracket, up to roughly $160,000, without going to the next tax rate.
The Roth conversation strategy has a lot of value today. It will be even more valuable when distributions are stacked into 10 years under the SECURE Act.
Clients should start working with their advisors now as the SECURE Act is expected to pass in the Senate and be signed into law before the end of the year.
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.”
Converting from a traditional IRA to a Roth IRA is a taxable event.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks nor any of its representatives may give legal or tax advice.