Stretch IRAs: Replicate, resurrect or R.I.P.
New tax legislation is passing through Congress aimed at addressing several retirement issues. One proposed change affects the stretch IRA rules. On the belief that this change may soon become law, multiple planners are already devising methods to replicate the presumably more favorable current-law treatment of these inherited IRAs.
Possibly the fate of this strategy should fall into a bigger debate about retirement tax planning. For many people, perhaps the best course for the stretch IRA is not to resurrect or replicate it, but let it die and rest in peace.
Stretch IRAs provide the opportunity to pass retirement assets to one’s children and grandchildren at death with little tax shrinkage thereafter through required distributions. The required minimum distributions for these inherited IRAs are minimal since they can be spread or stretched over the beneficiary’s lifetime. In final form, the modification of these rules may require much larger annual taxable distributions, possibly forcing 100 percent distribution of plan assets within 10 years, versus perhaps 30 or more years under the current rules.
The stretch IRA has been a valuable planning tool. Our probable future tax picture may make this less so and suggests more attention be paid to a significantly greater concern.
Political paralysis and the coming tax storm
There is a growing movement in the financial services industry to recognize and suggest planning for an inevitable and significant increase in tax levies. My informal poll of tax attorneys, CPAs and CFPs finds them unanimous in the belief that higher tax rates are unavoidable and may be with us for many years once they come to fruition.
According to USDebtClock.org, our national debt exceeds $22 trillion. Given the current tax rates, which are extremely low (from a historical perspective), it’s easy to understand our increased deficit spending. Of greater concern is the fact that politicians have been unwilling to address these issues and root problems like the rising cost of Social Security and Medicare. Therefore, it is almost inevitable that our long-term prospects may require significantly higher tax rates. Lest we think this a new phenomenon, consider that according to the Tax Policy Center the highest marginal income tax rate in U.S. history was 94 percent in 1944 and 1945. While the top rate was reduced after that, it was at least 70 percent for more than four decades (1936 through 1980).
Presidential candidates have announced proposals for tax increases on our wealthiest citizens through either a wealth tax, expanded estate tax or a 70 percent top income tax rate. None of these proposals is practical for a long-term solution to our debt problems. It will unfortunately require a significant and sustained tax increase on the middle class, which no politician will champion.
One of the key attributes of athletes is adaptability, adjusting to changing conditions or opponents doing the unexpected.
Twenty years ago, I coined the term “Olympic Investing.” It describes a strategy of adapting to changing circumstances during one’s retirement years when living off investment income for possibly 30 years or more.
An image similar to the Olympic rings provides a visual reference for using multiple income sources with different tax characteristics. This facilitates shifting income sources with the ebb and flow of tax rates as the political landscape changes. The coming tax storm seems to make it appropriate to increase the focus on accumulation options offering low to no tax when taking income during retirement.
Too few 401(k)s have Roth options that can provide tax-free income at retirement. Advisors have typically recommended deferring taxes now and paying them later on retirement distributions. Usually only individuals in low tax brackets are told to consider using a Roth option. Now, advisors who understand where tax rates are headed should consider recommending the addition and use of a Roth 401(k) component even for those currently in the highest tax brackets.
Supercharged Roth-like plans exist that allow unlimited amounts of contribution. They are specialized plans based on dual tax treaties with European Union countries. Their use has been slowly growing since 2011 since they can provide very significant and mostly tax-free retirement distributions.
Life insurance and its low-drag form (private placement) have long been used to accumulate funds without taxation to later provide tax-free distributions for life. A careful design can minimize cost and accumulation fluctuations.
Tax-managed investment portfolios may accumulate assets with minimal tax recognition. When transitioned to a distribution strategy, they may provide income which is partly tax-free and partly taxed at low capital gains rates.
Immediate annuities can provide guaranteed income for life. Favorable annuity tax rules may provide many years of income with extremely low tax recognition.
Deferred annuities with guaranteed income riders are functionally taxed at ordinary income rates. Their guarantees, flexibility and tax deferral may make them worthwhile planning tools if used judiciously.
None of these tools, by itself, is a recommended plan for retirement income. Combined, however, they can create a plan to provide many years of retirement income with the flexibility to roll with the tax punches our political system is sure to deliver.
What now for the stretch IRA?
Hopefully the stretch IRA will not be lost. But if it is, hopefully one of the plans to replicate it will take its place.
A key to the traditional use of the stretch IRA as a planning tool is its flexibility. Tax recognition can be minimized by spreading the taxable income over a lifetime if tax rates are high. When the rates are low, like now, tax recognition can be accelerated by increasing distributions above the required minimum. The ability to adapt to change is key to winning in the retirement income game, just as it is in the Olympics.