How to replicate a stretch IRA

The stretch IRA may be going away, but its spirit lives on in other tax-planning strategies

May 28, 2019 @ 4:39 pm

By Greg Iacurci

The end of the stretch IRA is nigh, and that's bad news for clients of financial advisers.

The good news: There are ways for advisers to simulate the benefits of a stretch IRA.

The term "stretch IRA" refers to an individual retirement account that's inherited by a non-spouse beneficiary. Current rules mandate that the beneficiary take required minimum distributions from the inherited IRA annually, but those withdrawals can be stretched over a long period of time — generally the life expectancy of the beneficiary.

This offers ample tax benefits for financial advisers and clients, including long periods of continued tax-free asset growth and, as a result of relatively small withdrawals, a lesser chance that the beneficiary edges into a higher tax bracket and pays more taxes on those distributions.

However, retirement bills moving through Congress, which observers think are likely to be signed into law this congressional session, would eliminate the stretch IRA.

While the stretch IRA is a unique vehicle, tax experts say there are strategies advisers can use to mimic many of its qualities.

"There may be ways to recreate certain aspects of a stretch IRA, but you can never replicate the whole thing," said Tim Steffen, director of advanced planning in Robert W. Baird & Co.'s private wealth management group.

(More: Should you name a trust as an IRA beneficiary?)

The SECURE Act, which overwhelmingly passed the House of Representatives last Thursday, is one bill that would kill the stretch IRA. It says beneficiaries must deplete inherited IRAs within 10 years of the owner's death. The Senate's proposal, the Retirement Enhancement and Savings Act, is slightly different — it would allow a stretch on the first $450,000 of aggregated IRAs, but require the rest to be distributed within five years.

The Joint Committee on Taxation estimates the SECURE Act's stretch-IRA provision would earn the government $15.7 billion in additional tax revenue over the decade through 2029.

If legislators curb the use of stretch IRAs, "every person who has a big IRA and likes their kids will want a plan," said Leon LaBrecque, chief growth officer at Sequoia Financial Group.

(More: Ed Slott: How tax reform impacted popular IRA strategies)

One strategy to generate the regular, flexible payments of a stretch IRA would be to fund an irrevocable trust with a life insurance policy. An IRA owner would take an account distribution to buy a life insurance policy long before their death, perhaps when they're in their 60s; at death, the policy's death benefit would fund a trust that's set up to pay a regular income stream to beneficiaries.

Growth in the trust wouldn't be tax-deferred as with a stretch IRA, but the trust can be set up to allow for flexible distribution amounts similar to a stretch. Plus, payments potentially can be spread out over decades (as long as there's money in the trust) as opposed to just 10 years or less.

Robert Keebler, founder of Keebler & Associates, said the insurance option may look better for clients who are likely to owe state or federal estate taxes, since the insurance would not be part of the estate.

Another strategy uses a charitable remainder trust that names a non-spouse beneficiary. The asset owner could fund the trust with IRA assets at death, and beneficiaries would get a regular income stream from the trust, similar to the required minimum distributions from an inherited IRA, which could be over a certain amount of time or the beneficiary's lifetime. The assets are only taxed when they leave the trust.

Upon the beneficiary's death, the trust's remaining assets would go to a predetermined charity. (The estate of the original IRA owner would claim the charitable deduction.) However, the trust payments are inflexible — based either on a percentage of the trust's assets or a fixed dollar amount. And a client would have to be charitably inclined in order for this strategy to make sense, Mr. Keebler said.

Similarly, clients could fund a deferred annuity at their death for the sake of a beneficiary, which would replicate the tax deferral and regular payment stream of a stretch IRA, Mr. Steffen said.

Mr. Keebler and Mr. LaBrecque both said they recommend clients who expect to pass on IRA assets consider Roth conversions in light of the elimination of stretch IRA. Both traditional and Roth IRAs would have to distribute their assets over a much shorter time frame if the new congressional rules go into effect — but beneficiaries' Roth distributions would be tax-free.

Under one scenario, an IRA owner could buy a life insurance policy whose death benefit would pay the taxes associated with the beneficiary's Roth conversion, Mr. Keebler said.

"I think this is way bigger than the estate tax changes recently, and it's way bigger than [the new pass-through deduction]," Mr. Keebler said of the potential elimination of stretch IRAs.

"Every financial adviser in the country probably needs another 10 to 20 hours of training," he added. "There are so many moving parts."


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