A Stretch IRA refers to the financial planning concept of designing an IRA (Traditional IRA or Roth IRA) for the maximum, tax efficient distribution of its assets as the account is inherited by succeeding generations. The SECURE Act of 2019 changed the rules for distribution for inherited IRAs. Prior to the SECURE Act, beneficiaries could distribute Inherited IRAs over their life expectancy with annual Required Minimum Distributions (RMDs) according to IRS Distribution Table I, and these were referred to as "Stretch IRAs." Following the SECURE Act, most Inherited IRAs have no annual RMDs, but must be completely distributed by the end of the tenth year following the owner's death.
It remains to be seen whether these Inherited IRAs will also be referred to as "Stretch IRAs" by the financial planning community. For clarity, IRAs governed by the pre-SECURE Act distribution rules will be referred to as "pre-SECURE Act Stretch IRAs" and IRAs governed by the new ten-year rule will be referred to as "post-SECURE Act Inherited IRAs."
Pre-SECURE Act Stretch IRAs
IRAs inherited before January 1, 2020 (excluding those inherited by a surviving spouse who elects to treat the IRA as their own) still follow the pre-SECURE Act Stretch IRA rules. However, the SECURE Act offers several exceptions (see below) to the ten-year rule, in which case Stretch IRA rules also apply. When the designated beneficiary who inherited an IRA prior to 1/1/2020 passes, the ten-year rule will apply to the successor beneficiary, unless one of the exceptions applies to the successor beneficiary.
Pre-SECURE Act Stretch IRAs have Required Minimum Distributions (RMDs) for the beneficiary that begin the year after the owner died, regardless of the beneficiary's age. However, the life expectancy for which the RMDs are calculated will be at least several decades for most beneficiaries, so RMDs will initially be small. See the RMD page for details on this calculation.
Note that for 2020, RMDs are not required due to the CODIV-19 pandemic.
Roth Stretch IRA withdrawals have no tax consequences, so unless you have an overriding need for the money, the best strategy is to take only RMDs and no more. Traditional Stretch IRA withdrawals are partly or fully taxable, and so can have significant tax consequences, especially with larger balances. While the initial RMD from a Stretch IRA will be small (less than ~4% for those under age 60), RMDs get larger over time, and can get very large in the second-to-last year of distribution, when the life expectancy factor will be between 1 and 2. This results in between 50-100% of the remaining balance being distributed in a single year. If this large distribution causes tax problems, beneficiaries should consider an accelerated distribution schedule beginning at least ten years from the year when the IRA must be fully distributed. While the last large RMDs will be the same percentage, they will be on a smaller account balance, reduced by larger earlier withdrawals.
Stretch IRA owners should also consider estate planning tax strategy. If you have health issues or otherwise think you might not live to the final distribution of your Stretch IRA, you should consider what tax structures you would prefer to leave in your estate. Low-tax heirs may prefer to inherit the remainder of your Stretch IRA (which they would then need to distribute according to the SECURE Act's ten-year rule, unless an exception applies), especially if their ten-year window is longer than than the time until you would be required to fully distribute the account. In such a case, it may be advisable to make only minimum distributions. However, if your heirs are high-tax, it may be advisable to take accelerated withdrawals and invest in tax-efficient assets in a taxable account. The investments will grow with low tax drag, and your heirs will inherit them with a step-up in basis, a significant tax savings.
SECURE Act Inherited IRAs
IRAs inherited on or after January 1, 2020 do not have any annual Required Minimum Distributions (RMDs), but must be completely distributed to their beneficiaries by December 31 of the tenth year after the death of the owner. Beneficiaries may potentially make withdrawals in eleven tax years, if the owner died early enough in the year. The SECURE Act excepts the following beneficiaries from the new ten-year rule, in which case the pre-SECURE Act Stretch IRA rules govern:
- Surviving spouses who elect to treat the IRA as an Inherited IRA rather than their own (surviving spouses still have the option to treat Inherited IRAs as their own)
- Minor children of the decedent, until the child reaches the age of majority (at which time the ten-year rule begins with a fresh clock). This change can be deferred as late as age 26 if the child is pursuing higher education.
- Any beneficiary not more than ten years younger than the decedent
- Chronically ill beneficiaries
- Permanently disabled beneficiaries
There can be complexity and/or legal ambiguity surrounding the details of some of these definitions.
Plans maintained pursuant to a collective bargaining agreement, and governmental plans (such a 403(b)'s for government employees and governmental 457(b)'s) are not impacted by the ten-year rule until January 1, 2022.
Post-SECURE Act strategies for beneficiaries
Roth IRA withdrawals are tax-free, so unless the beneficiary has an urgent need for the funds, the best strategy will generally be to leave the funds inside the Inherited IRA as long as possible, and withdraw a lump sum toward the end of the tenth year after the owner's death. This will maximize tax-free growth. Reasons for deviating from this strategy could include:
- The beneficiary is not able to maximize contributions to their own tax-advantaged accounts, for example, by having access to a large Solo 401(k) or Mega Backdoor Roth limit. Withdrawing distributions from an Inherited Roth IRA to make these contributions would be trading one tax-advantaged space for another, but the beneficiary's own accounts do not need to be closed down in ten years or less, and so provide much longer-term tax-advantaged growth potential than the Inherited IRA.
- The beneficiary has debt with a higher interest rate than the expected tax-free return of investments available in the IRA. While the debt probably should not have been taken out in the first place, withdrawing Inherited IRA money to pay it off may be the best solution, along with addressing the problems that led to the debt in the first place.
- Attractive taxable investments (real estate, private equity, etc.) are available that have higher return potential than the investments inside the Inherited IRA.
Traditional IRA withdrawals are taxable (or at least partly taxable if the IRA has any non-deductible basis) so substantial withdrawals can have severe tax consequences. In deciding the best withdrawal strategy, an investor should first understand their tax situation, particularly their marginal tax rate for various sizes of withdrawals, including federal and state income tax rates, phase-outs of deductions and credits, and other income-based effects such as IRMAA, student loan interest subsides, and financial aid. This information can be obtained from a professional tax preparer, tax software, or other tools such as the Personal Finance Toolbox. This information should be estimated, as best as possible, for the next ten years. Factors that affect future income and tax rates could include:
- Planned start or stop of working, for you or your spouse
- Fluctuations in income, including certain career paths that have large changes in income when milestones are reached
- Planned moves between low-tax and high-tax states
- Planned large charitable gifts
- Expected start of Social Security or pension payments
- Possible future leaves of absence (eg. connected to a new child)
- Expiration of Tax Cuts and Jobs Act reduced individual income tax rates in 2025 (if not modified by new legislation), and possibly other future tax law changes
Note that beneficiaries may be able to spread withdrawals over 11 tax years, rather than 10, if the owner died early enough in the year for the beneficiary to make a withdrawal before December 31.
Planned IRA withdrawals could affect Traditional versus Roth decisions in those years for your own accounts, for example, by favoring Traditional contributions in years with large withdrawals.
A lump-sum withdrawal in the final year maximizes tax-deferred growth, but also concentrates taxable income in a single year, possibly causing the highest average tax rate on withdrawals. This strategy could be optimal in the following situations:
- The IRA balance is small enough such that the lump sum does not push the taxpayer into a higher bracket (eg. as of 2020, the federal 24% married bracket spans over $150,000)
- High-income taxpayers who are already in the top (37%) tax bracket, and are not affected by other factors that would increase the tax rate on the lump sum
- Taxpayers who are just below large spikes in tax rate (eg. due to taxation of Social Security benefits or phase-out of Section 199A deductions) with lower rates above may pay a lower average tax rate by taking a large withdrawal in a single year instead of paying a spiked rate for many years
Level, or approximately level, withdrawals minimize the greatest taxable income in any given year. This strategy could be optimal in the following situations:
- A lump-sum withdrawal would raise the taxpayer into a higher marginal tax rate than 10 or 11 level withdrawals
- The taxpayer is not able to fully contribute to tax-advantaged accounts without annual withdrawals. Withdrawing from the Inherited IRA and contributing to personally-owned accounts is either tax-neutral (for traditional contributions) or has the effect of a Roth conversion (for Roth contributions), but moves funds into an account without a ten year limit.
The following table gives the approximate percentages of the balance that should be withdrawn each year as a function of expected real rate of return, assuming withdrawals are made at year-end and tax brackets are indexed for inflation:
|Remaining Withdrawals (Including Current One)|
Accelerated withdrawals will concentrate taxable income in one or several years, and will also forego tax-deferred growth, so will not be optimal for the majority of beneficiaries. However, this strategy could make sense in certain situations, for example, if you suspect you may not live for the entire ten-year distribution period (due to age, health, or other reasons), and are going to leave your assets to higher-tax heirs. In this case, front-loaded withdrawals can be used to pay the tax on Roth conversions of other pre-tax assets (if it can be done at a lower tax rate than your prospective heirs), and/or invested in tax-efficient assets in a taxable account. The investments will grow with low tax drag, and your heirs will inherit them with a step-up in basis, a significant tax savings.
Irregular withdrawals are the preferred strategy when you expect your tax situation to be significantly different years within the ten year withdrawal period, due to any of the factors listed above. Larger withdrawals should be timed to occur in years where the marginal tax rate is lowest.
Post-SECURE Act strategies for owners
The SECURE Act may dramatically change estate planning for those expecting to bequeath substantial IRAs. Prior to the SECURE Act, distributions of Inherited IRAs could be spread over many decades, so the ten-year rule is a dramatic acceleration of required distributions. In response, more complex inter-generational tax planning may be needed to maximize the after-tax value of your estate. Not only will you need to consider your own tax situation, but also the likely tax situation of your prospective heirs. The following strategies should be considered by account owners expecting to leave substantial pre-tax funds in IRAs.
Spreading out Traditional IRAs over many beneficiaries
Before the SECURE Act, it may have been advantageous to prefer leaving IRAs to younger heirs, to maximize the time period of the stretch. Now, all heirs will need to distribute their Inherited IRAs over roughly the same time period, so distributing pre-tax IRA assets roughly equally among all heirs may now be a better strategy.
Further optimization can be achieved by tax-adjusting the values of each heir's inheritance based on their expected tax rate. For example, pre-tax assets may be left predominantly toward low-tax heirs, taxable assets to middle-tax heirs, and Roth assets to high-tax heirs. While this was also advisable prior to the SECURE Act, the shorter distribution period for younger heirs will change the effective tax rate calculation. You should consider that this could cause consternation among heirs. For example, lower-income heirs might not fully understand why the nominal value of their share of the inheritance is smaller than their higher-income siblings, or high-income heirs may not understand why the nominal value of pre-tax assets left to lower-income heirs is greater than the value of their Roth assets.
Partial Roth conversions of pre-tax assets during your lifetime will increase the time over which the taxable income is distributed, thus reducing the taxable income per year. If the marginal tax rate of a Roth conversion is less than the marginal tax rate of withdrawals by your heirs, then the Roth conversion will save taxes. This strategy is similar to doing Roth conversions prior to the start of RMDs to reduce the taxable RMD amount.
Bypassing the spouse
A married couple may be able to extend the window over which their heirs will need to distribute pre-tax assets by partially bypassing the surviving spouse. Each spouse would leave some or all of their pre-tax assets directly to their younger heirs, as opposed to their spouse. When the first spouse dies, the ten-year clock begins on those withdrawals. When the surviving spouse dies and bequeaths the remaining pre-tax asses, those accounts get a fresh ten-year clock. This strategy can broaden the effective distribution period to up to 22 years.
For large IRAs, advanced strategies using a Charitable Remainder Trust may be able to artificially create similar rules to the Stretch IRA, albeit with additional cost and complexity. If you think this may be an appropriate strategy for you, consult a competent estate planning attorney in your state.
- Julie Jason (April 16, 2020). "Why The 2020 RMD Suspension Is Not Fair To All". Forbes.
- The (Partial) Death Of The Stretch IRA: How The SECURE Act Impacts Inherited Retirement Accounts, Jeffrey Levine CFP, Kitces Nerds Eye View, February 12,2020.
- Strategies To Mitigate The (Partial) Death Of The Stretch IRA, Jeffrey Levine CFP, Kitces Nerds Eye View, February 19,2020.
- Bogleheads® forum topic: , Thor OnionLover. Dec 05, 2009
- Bogleheads® forum topic: , fyre4ce. Mar 24, 2020. Forum discussion of page expansion following the SECURE Act.
- Want To Leave Money To Your Family? Stretch Your IRA, Denise Appleby, Investopedia
- Strategies to Mitigate The (Partial) Death of the Stretch IRA, Jeffrey Levine CFP, Kitces.com blog, Feb 19, 2020
- SECURE's Changes to Retirement Plan Distribution Rules Applicable to Participants and Beneficiaries, Natalie B. Choate, Esq., Nutter McClennen & Fish, LLP, 21 January 2020