5 Stretch IRA Alternatives to Consider

March 6, 2020

There is good news and bad news for retirement savers whose stretch-IRA strategies were upended by the Secure Act: There are workarounds, but none necessarily offer a perfect replacement for the popular estate-planning tool.

Passage of the most sweeping retirement legislation in more than a decade means certain beneficiaries can no longer take advantage of the “stretch” opportunity where a traditional individual retirement account could be drawn down over their lifetime to minimize the tax burden. Now, most non-spousal beneficiaries would have to deplete the account within 10 years.

The upshot is that some owners of traditional IRAs will seek alternatives, says Joe Salvati, senior wealth advisor at the Colony Group. While there is no cookie-cutter solution, he says, an investor’s course of action can depend on factors such as the size of the IRA, the size of the estate, current tax rates, future expected tax rates, whether the IRA distribution changes make a significant difference to his or her personal planning objectives, and what other options exist that might make sense from a cost and practical perspective.

Here are a few options to consider.

Convert to a Roth IRA

Investors who are willing to pay taxes now should consider converting a traditional IRA to a Roth IRA. Any taxes paid would ideally be at a lower rate than the beneficiaries would pay in the future. Plus, those tax payments to Uncle Sam would help reduce their estate, which may be ideal for wealthy investors concerned about the federal estate-tax exemption returning to $5 million (adjusted for inflation) in 2026, from the $11.58 million per individual it is at now. The Roth IRA would still be part of the estate, of course, and most non-spouse beneficiaries will still have to deplete the IRA in 10 years. However, Roth IRA distributions will be received tax-free by each beneficiary.

Name a charitable remainder trust as the IRA beneficiary

After the IRA owner’s death, the IRA funds would be paid to the trust and then to the trust’s beneficiaries (such as children or grandchildren) in accordance with the trust agreement, says Lisa Featherngill, head of legacy and wealth planning at Abbot Downing in Winston-Salem, N.C. This approach gets around the 10-year rule and it allows the IRA owner to dictate the term of the distributions, she says.

Charitable goals can also be satisfied with this approach, though setting up the trust and the ongoing administration can be costly. Also, beneficiaries could have to pay taxes when they receive distributions. There’s no way around the charitable function; a certain percentage must be left for charity.

You don’t have to be ultra-wealthy to consider this strategy, but it’s not for everyone. There are costs involved, including legal drafting fees that could run a few thousand dollars. There’s also an annual trustee fee unless a family member administers it.

Buy life insurance

This might be a viable option for someone between the ages of age 59½ and 72, when required minimum distributions aren’t mandatory and early-distribution penalties aren’t an issue, says Jack Cintorino, senior financial planner at Janney Montgomery Scott.

With this strategy, IRA owners could use distributions to buy cash-value life insurance, naming a child, grandchild, or a trust as beneficiary. They would pay income tax on the IRA distributions used to fund the policy, but by doing so, they also would be reducing the size of their estate. The funds in the policy would then grow tax-free. The funds are generally distributed in a lump-sum once the owner dies, though there may be other options if a trust is the beneficiary.

Here’s another option for wealthier individuals who want to get money out of their estate: set up an irrevocable trust for the purpose of purchasing life insurance. It’s an added cost to set up the trust, but “the life insurance can be placed outside the reach of the taxman through the use of a trust—saving a possible 40% tax on the estate,” says Steve Parrish, co-director of the Retirement Income Center at the American College of Financial Services. The downside to this strategy is that the trust is irrevocable and therefore difficult to undo, so don’t do it if you think you’ll need the money to live on, he says.

Also know that if you’re thinking of buying life insurance, it may be prohibitively expensive depending on age—or unattainable, depending on the person’s health, advisors say.

Irrevocable trust

IRA owners could also consider funding an irrevocable trust for their children, funded with non-IRA assets, to help mitigate any projected loss in value that their children may experience in the future because the stretch opportunity no longer exists, says John Voltaggio, managing director at Northern Trust Wealth Management.

Funding a trust also gets the money out of the IRA owner’s estate sooner than leaving an IRA at death. The trust can be structured to provide a regular income stream—which can go beyond 10 years—and provide asset protection to beneficiaries, he adds.

Of course, IRA owners should aim to have enough to live on before going down this path because the assets of an irrevocable trust belong to the trust beneficiaries and generally terms can’t be modified without their permission. They should also be aware that assets in the trust don’t grow on an tax-deferred or an tax-free basis.

Do nothing

For many traditional IRA holders, it may simply not be worth the trouble—and potentially added expense—to find a workaround. It’s hard to quantify how much the non-spousal beneficiaries stand to lose because there are so many unknowns, and smaller IRAs are likely to be depleted anyway during the owner’s lifetime, advisors say.

If there are leftover funds, beneficiaries can still spread distributions over 10 years, mitigating the tax hit, or IRA owners can name multiple beneficiaries, which will also lessen the impact.

Importantly, IRA owners should avoid knee-jerk reactions that “end up creating more fees or generating lower returns in an effort to mitigate the implications of the change,” says David Snider, founder and CEO of Harness Wealth, a digital platform that matches investors with financial-planning, tax and estate-planning experts.

Originally Published on Barron’s
Written by Cheryl Winokur Munk