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How Stretch IRA Tactics Have Tightened

Tax expert Ed Slott discusses the new rule for inherited IRAs.

Christine Benz: Hi, I'm Christine Benz from Morningstar. The Secure Act ushered in new rules for inherited IRAs. Joining me to discuss what you need to know about that is author and tax-planning expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be back with you, Christine. Thanks.

Benz: It's great to have you here. I'd like to discuss this new rule for inherited IRAs-- the new rules that beneficiaries must follow--following the passage of the Secure Act. Can you talk about that?

Slott: Well, this is important because it's effective now. Actually, it became effective in 2020. But most people, most beneficiaries, would start now for a death in 2020. That's when it became effective. And the big change that beneficiaries need to know about is something we used to call the stretch IRA. That was the ability for beneficiaries to differ over their lifetime. They could go out 20, 30, 40, 80 years for a 2-year old and stretch, or extend, the payouts on their inherited IRA over their lifetime. That ended beginning in 2020. So anybody who inherits in 2020 is under the Secure Act and was replaced, for the most part, with something called a 10-year rule, which means instead of that long stretch or extended payout period, most nonspouse beneficiaries will have to empty their inherited IRAs, or inherited Roth IRAs, by the end of the 10th year after death. The problem or the confusion was when IRS released their signature publication on this: 590-B. It's corrected now. But that's like the Bible. And it's normally a big nonevent. It's just a wrap-up of the new rules. These things come out every year. But they had an example in there telling people how the 10-year rule would work, and it was wrong. I think it was copied actually from a prior year. And they just upped the years but didn't change it for the Secure Act, like the Secure Act didn't exist.

So all the estate attorneys, it was in all the professional conferences, they said, "You know, IRS is saying under this 10-year rule, the beneficiaries have to start taking every year for 10 years." That is not the case. In May, they came out with what they call a revised updated--you know, they never say there's an error in there--an updated publication 590, that made it clear. They got rid of that example, actually replaced it with a worse example, but in other parts of the publication, they made it clear that under the 10-year rule, there are no required distributions for the 10 years except at the end of the 10th year. So the only required payout to beneficiaries is whatever the balance is at the end of the 10th year after death--that has to come out. But you can do whatever you want in the 10 years--actually gives beneficiaries a lot more flexibility. They can do whatever they want in the 10 years. Maybe a beneficiary, let's say, a son, inherits at age 50. But he's still working, making a good income. So he's retiring, maybe, in three or four years. He's not going to take anything while his income is high. And maybe he'll take distributions once he retires in years seven, eight, nine, and 10. So you have a lot of planning flexibility, but the stretch is gone for just about every beneficiary except the surviving spouse.

There are some other exceptions. The surviving spouse is unaffected. They have the same rights and privileges. And that's good because most people that are married leave their IRA or Roth IRA or 401(k) to their spouse. There are four other categories of exceptions, people who still get the stretch, but it's not many people. One category is very confusing: It says a "minor" beneficiary. So people are saying, "So what's the big deal? If the minor beneficiaries still get the stretch IRA, I'll leave it to my grandchild. It'll go out 80 years." Not grandchildren. It has to be a minor beneficiary of the deceased IRA owner or deceased 401(k) participant. So, for example, that's not going to be many people. If the average IRA owner dies, I don't know, at age 85. What's the likelihood of that person having a 12-year-old child? The only one I can think of is Tony Randall, and he's dead. So it's not a common situation. Where it'd be more common: A 40-year-old unfortunately dies early and has a teenager, but then there wouldn't be as much involved generally. So even with the minor beneficiary, if you have that situation, it's only up until they reach the age of majority, which is 18 in most states, or they can actually go till age 26 if they're still in school. But after that, they're back on the 10-year rule. So that's the minor category. That's why that's confusing, not grandchildren.

Then you have disabled, chronically ill, and this weird category of beneficiaries not more than 10 years younger than the IRA owner. People around the same age--a nonspouse. It'd be a partner, a friend, a brother, a sister. I guess Congress figured, "Eh, they're about the same age. Let them have the stretch IRA. How long are they going to live anyway?" So those are the categories that are exempt, that still get the stretch. But there's one more important category: anyone who inherited before 2019. So if you left your IRA--well, you would be dead--but in 2019, to your grandchild who was 2 years old, that grandchild can go out--let's say they inherited, you died on Dec. 31, 2019. That grandchild can stretch it out, if he lives long enough, for 80 years. But let's say instead, you died on Jan. 1--the next day: 10-year rule. So you have to keep track of these two sets of rules. But here's the good news. This will only go on for about 80 years, until all the people who inherited before 2020 are kind of washed out of the system. So it is grandfathered for anybody who inherited before 2020 they still get the old rules.

Benz: You've been talking mainly about people who inherit, but what about people who are planning? If their goal was for their loved ones, say their children, to be able to extend the tax benefits in the way that they were able to do under the stretch, is there any alternative that simulates that same tax deferral, or not really?

Slott: Yeah, there are alternatives. And that's what everybody's focusing on--the planners are. Because what Congress did--they actually made IRAs and even Roth IRAs less valuable for wealth...they actually downgraded these accounts, as far as wealth transfer or estate planning, which is exactly what they wanted to do. Congress felt IRAs or retirement accounts should be for retirement and not as an estate planning vehicle to pass on for generations. So they made it less valuable. So now the IRA is not a valuable asset. It's like an old jalopy that is pooped out at death. So you got to get rid of that. You know, it used to be the vehicle that got you this big stretch IRA, but you're not married to it. Change the vehicle. Get rid of the old IRA jalopy, and get into, maybe, a limo for the rest of the ride, you know, a luxury limo.

And there's ways to do that. One way is to start bringing down that IRA balance. And it affects, the people most affected, are people with the largest IRAs because there's more likely to pass on to beneficiaries that won't be spent during their lifetime. So you might look at lifetime Roth conversions to get that balance down. And even though the children or grandchildren might have to take it out in 10 years, the Roth isn't a bad asset. They could leave it there for 10 years, growing totally tax-free. They still have to get it out at the end of the 10th year, but all of that growth will be tax-free at the end of the 10th year. That's one option.

Another option is to get rid of the IRA, not all, but everything in moderation, and maybe look to life insurance. Now, just so you know, I don't sell life insurance. I'm a tax advisor. I don't sell stocks, bonds, funds, insurance, annuities, but as a tax advisor, I have to tell you, the tax exemption for life insurance is among the single biggest benefits in the tax code, not used nearly enough. You could take down some of that IRA--assuming you don't need it, and it's meant to pass on to beneficiaries--and, like you said, Christine, simulate that stretch IRA. And then pay the tax and put the money into life insurance, which can be given or left to a beneficiary directly--or in trust, if you're worried about the control or them blowing the money or squandering it or something like that ... lawsuits, bankruptcy, all the things people worry about with their kids. And that can be customized to simulate the stretch or even better. You'll remember with the life insurance, there are no stretch IRA rules, there are no RMDs, there's no tax rules, and there's no tax. So that's one option.

For the charitably inclined: charitable remainder trust. And the key is you have to have a strong charitable intent. Remember, IRAs are the best assets for those charitably inclined people to give to charity. So instead of leaving it to your children, better off to leave them other non-IRA assets that they hopefully can get a step-up in basis on, and leave the IRAs to, say, a charitable trust. The IRA goes to the charitable trust at death. The charitable trust, a CRT, would pay income to your beneficiaries for a term of years or for life. And they would get these payouts, which can simulate a stretch IRA. But there's a warning there. I would never do that unless there was strong charitable intent and it was coupled with a backup life insurance policy. Because if that CRT beneficiary, your child, or children, let's say, dies early, that's the deal--the money goes back to the charity. So you would want to have a life insurance policy on that beneficiary so if the beneficiary dies early, at least the family is made whole and it's tax-free. Also, you have to be aware there are no extra payments. For example, if a beneficiary is getting these monthly or annual payments from the charity, that's what they'll get. Now, some parents like that to control it. But let's say they need an extra $50,000 or $100,000 for some business, medical, financial emergency--no deal, they only get the payment. So you have to take that into consideration. I think the CRT, the charitable remainder trust, is more for, let's say, $1 million IRA or over. There's administrative trust taxes. It involves a lot, but it's one way to simulate the stretch IRA, have your charitable intentions flourish with the IRA, the best asset to leave to a charity, and take care of your beneficiaries to simulate the stretch IRA. Other than that, the best thing is to use a lot of your IRAs through QCDs during life, the qualified charitable distributions, and get that money out at the lowest possible tax rate.

Benz: Ed, you always bring such great information. Thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.