Under current law, a beneficiary who inherits an IRA account can leave the money in the IRA and continue to defer income taxes on that money over the beneficiary’s lifetime. This is often called a “Stretch IRA” because the income taxes and withdrawals are stretched out over the beneficiary’s lifetime. It gives the inheriting beneficiary a valuable option to defer income taxes.

Since 2012, Congress has been considering changes to the IRA rules. While the changes will generally make IRAs more flexible and valuable, in order to pay for those new IRA features Congress unfortunately plans to take away the Stretch IRA option after death. The new law will require beneficiaries to withdraw all of the money from the inherited IRA account within either 5 years or 10 years (at this point the Senate and the House of Representatives do not agree on the number of years involved). When Congress finalizes these changes, IRA beneficiaries will be forced to pay all income taxes in an IRA account much sooner. A beneficiary inheriting an IRA could be forced to pay higher income taxes because the IRA money will show up on the beneficiary’s tax return in what is typically their highest tax bracket years.

Congress has not passed the new law yet, but it is generally considered to be inevitable. However, in many cases the change will not affect beneficiaries as much as it might initially appear. There are planning options that can allow the IRA’s owner and their family to hold on to some of the tax deferral benefit.

Minor Children. Most parents of minor children create trusts for the benefit of the children in their Will or Revocable Trust. These trusts generally hold the child’s assets to pay education and other expenses. When the child reaches age 25 or 30 the trust ends and the remaining balance in the trust is distributed to the child outright.
The new rules will exempt IRAs that name minor children as the beneficiary. The 5 year or 10 withdrawal period on an inherited IRA will not begin until the child turns age 18. This means that a trust set up for a minor child will be allowed to defer distributions and delay the income taxes through the pay-out period of the trust when it is covering college or other education expenses. The balance of the IRA can be held until the child reaches age 23 or 28, when the trust might have distributed the balance of the trust anyway. In either case, the result is the very close to what was intended when the trust was set up for the child. The parents of minor children thus do not need to make changes to their estate plan due to the new IRA rules.

Trusteed IRAs. A number of financial institutions offer a “trusteed IRA” as a beneficiary designation option when the Stretch IRA option is eliminated.. These arrangements are essentially intended to give the IRA owner all of the benefits of a trust that a lawyer would draft, but without the need to actually hire the lawyer. As with so many simple arrangements that sound great, these trusteed IRAs are far more complicated then they appear on the surface. When the IRA rules change it will trigger some particularly tricky provisions hidden in the trusteed IRA contract.

Trusteed IRAs will probably cause higher income taxes for the beneficiaries when the Stretch IRA option in eliminated. If you choose to use the trusteed IRA you will have the responsibility to drill down into the IRA documents and make some changes so that the default provisions do not take over and give the family a higher income result.

Large IRA Balances. If the loss of the Stretch IRA option will potentially drive up income taxes for a family, the harm will be magnified if the balance of the IRA account is larger. Fortunately, there are some steps that a family can take to work around that very large income tax bill. A number of strategies were developed to reduce or eliminate estate taxes when estate taxes were a significant problem in the 1980s and 1990s. These tools will work just as well to reduce or avoid a large income tax bill on an IRA. If you have a large balance in your IRA you can add those tax management tools to your estate plan when you are working with your estate planning attorney.

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