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Getting Rid of Stretch Marks

Rick Roeder, FSA       February 2020

A small piece of unheralded December 2019 legislation will have adverse tax consequences on certain beneficiaries of deceased who had accumulated significant assets in their IRA account(s). For those who died in 2019 or prior, the mandated minimum IRA payout to beneficiaries was predicated, in large part, on the age of the beneficiary.

Suppose a person had died in 2019 with $1 million in their IRA account. Let’s further assume that their 40-year old child was the sole beneficiary. Under former law, let’s assume the child’s remaining life expectancy was roughly 40 years. Dividing 40 into 1 million produces an initial minimum annual payout of $25,000. Not only would the $25,000 usually be insufficient to move one into a dramatically higher marginal tax rate, the relatively small payouts mean that there was an opportunity for significant investment income, on a significant tax-deferred basis, during the lengthy payout period. Such minimum payments will generally increase over time due to tax-deferred investment income. In this example, let’s assume that the IRA monies earn annual investment earnings of 5%. Total anticipated payouts to the deceased’s child would exceed $3.2 million over the 40-year period. A 6% annual investment yield would increase total payouts to $4.2+ million. Hence, the nickname “stretch IRA.” If you like numeric details, we offer examples during the payout period (at end of article).

New days now! To avoid a punishing 50% tax on IRA assets, the maximum time for payouts has been markedly diminished to 10 years, unless a beneficiary fall into one of the exceptions (less than 10 years younger than deceased, a minor child or a surviving spouse). Let’s revisit our previous example. The initial minimum payout would increase to $100,000. In a 5% investment scenario, total anticipated payouts to the deceased’s child would be $1.3 million over the 10-year period. A 6% annual investment yield would increase total payouts to $1.4 million.

If a beneficiary is already in a reasonably high tax bracket, the IRA holder can elect to take an immediate tax hit by converting the IRA to a Roth IRA (where subsequent investment income is not taxed). The greater the anticipated income during the subsequent 10 years after the account holder’s death, the more attractive the Roth option. The Roth option is also attractive if one’s view is that future tax rates will increase. Another tax planning option would be to designate multiple beneficiaries.

The Ramble wonders if this legislation signals the beginning of a trend toward higher taxes on estates. The opposite has certainly been true in the 21st century. In 2003, the federal estate tax exclusion was $1 million, less than the 10% of the current exclusion amount of $11+ million. Wow! The Ramble will wonder more vigorously if the Democrats do well in the 2020 elections.

Guest authors are welcome to submit articles and their thoughts to the ROEDER RAMBLE for potential viewing on this site.