Retirement accounts and estate plans may soon be taking a major hit from the IRS, if Congress decides early next year to change the rules on a tax strategy involving inherited IRAs that many families have used to their advantage for years.
Under current rules, people who contribute to an individual retirement account and don’t need the money to meet retirement living expenses are able to pass the account along to their heirs. That money is then allowed to keep growing tax-deferred throughout the heirs’ lifetime, with minimal taxes due on the withdrawals.
But the ability to stretch an IRA across generations could be coming to an end.
The Senate Committee on Finance voted 26-0 in September to kill the “Stretch IRA” for non-spousal beneficiaries – putting trillions of dollars of legacy wealth in danger of being collected by the tax man.
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“This is going to be big,” said James Lange, a Pittsburgh-based tax accountant, attorney and author. “It’s not a done deal. It’s not immediately effective. But in the past when you had a 26-0 Senate vote, the legislation always became law the next year.”
The Senate proposal will be included in a bill called the Retirement Enhancement and Savings Act, and would require beneficiaries of an inherited IRA or other qualified retirement account to pay all taxes due on the account within five years of the owner’s death.
The proposed law does not apply to surviving spouses. Surviving spouses may still spread the taxes due on the account across their life span or roll the money into another retirement account.
As it stands, the proposal includes a $450,000 exclusion, which applies to non-spouse beneficiaries. A $1 million inherited IRA would only be subject to taxes on $550,000.
The proposed rule would not affect Roth IRAs because taxes on those accounts have already been paid with after-tax income by the account owner.
Taxes on traditional IRAs are deferred until the account owner begins making withdrawals to cover living expenses during retirement. Heirs are required to continue making annual withdrawals from the inherited account and pay taxes on those withdrawals. The new rule would dramatically speed up the pace of those withdrawals.
“The five-year limit isn’t so bad if you are paying taxes on $100,000, but if you have $500,000 to pay taxes on, it could be a challenge,” said Howard Davis, president of the Davis, Davis & Associates accounting firm in Pittsburgh.
Davis has several clients with IRA balances of $1 million or more. “You could wait until year five to pay the entire tax bill, but it could also push you into a higher tax bracket.” He said it probably makes more sense to take out a portion each year to lower the tax ramifications.”
What’s at stake
The total amount of money at stake is substantial.
Total U.S. retirement assets were $24.5 trillion as of June 2016, up 1.3 percent from the end of March, according to the Washington, D.C.-based Investment Company Institute. Retirement assets accounted for 34 percent of all household financial assets in the U.S. at the end of June.
In the average American household, second to the home, the retirement account is the household’s largest source of wealth. The ability to transfer that wealth to the second or third generation will fall away with this legislation.
Jim Meredith, executive vice president of the Hefren-Tillotson financial advisory firm in Pittsburgh.
“Currently, Congress has to wait about 40 years to get the assets in retirement accounts converted into income tax payments,” said Jim Meredith, executive vice president of the Hefren-Tillotson financial advisory firm in Pittsburgh. “If non-spousal beneficiaries must pay the tax bill off in five years instead of over their actuarial life span, there will be a huge windfall for the government.
“In the average American household, second to the home, the retirement account is the household’s largest source of wealth,” Meredith said. “The ability to transfer that wealth to the second or third generation will fall away with this legislation.”
Individuals who inherited traditional IRAs have been able to profit from one of the biggest benefits of the tax code – allowing the tax-deferred balance to continue compounding all those years.
For example, assume a son inherits an IRA upon the death of his father in 2016. The son will turn 53 in 2017, when required distributions based on his life expectancy commence. The IRA Single Life Expectancy Table indicates that at age 53, the son has a 31.4-year life expectancy.
In 2017, the son’s required minimum distribution amount, which he would be required to pay taxes on, would be computed as follows:
The balance of his inherited account on Jan. 1, 2017, times the fraction 1/31.4. For the years after 2017, the son reduces his life expectancy by one year from what it was in 2017. So in 2018, his required minimum distribution fraction is 1/30.4.
This minimum required distribution fraction applies to the son’s inherited IRA even if the son dies. The Internal Revenue Service really doesn’t care who the account passes to at that point, since it has no affect on the required minimum distribution rate from the inherited IRA, which was set in 2017.
Why the change
The trigger for the changing status of inherited IRAs may stem from a 2014 U.S. Supreme Court decision on a traditional IRA lawsuit involving Heidi Heffron-Clark, of Madison, Wis., who became the sole beneficiary of an inherited IRA when her mother died in 2001.
In 2010, Heffron-Clark and her husband filed a Chapter 7 bankruptcy petition. They identified the inherited IRA – which by then was worth about $300,000 – as exempt from creditors on the basis that the money came from a retirement account.
Bankruptcy courts had until then typically held that inherited retirement accounts may be excluded from a beneficiary’s bankruptcy estate. However, the Supreme Court ruled unanimously that inherited IRAs are not “retirement funds” under the bankruptcy code and are not entitled to exemption from a debtor’s bankruptcy estate.
The Supreme Court concluded that inherited IRAs are not funds set aside for the day when an individual stops working. The fact that a beneficiary can never contribute additional funds to the account doesn’t square with the notion that the fund is money the beneficiary is putting aside for retirement.
“The Supreme Court said that non-spouses are not exempt,” Meredith said, adding that Sen. Harry Reid, D-Nev., later proposed that as inherited IRAs are not retirement accounts, they should receive the same tax treatment as a non-IRA annuity. That meant the inherited IRA account would need to be redeemed within five years of inheritance.
Lange said people who never earned a ton of money but were prudent about setting aside funds into retirement plans will die with lots of money in those plans.
“The IRA is the main source of wealth in their 60s. What will happen under the proposed law is IRAs will be taxed more heavily and it will make a big difference for heirs.”