The SECURE Act, a major piece of retirement legislation, was passed in the House Of Representatives back in May. It’s yet to come up to a vote in the Senate, but the likelihood is it will get passed sooner or later. The Act contains many attractive features for retirement savers. However, there is one piece that many are not in favor of. New rules will eliminate the benefits of the so-called “Stretch IRA.” Here, we’ll discuss the SECURE Act and the rules concerning inherited IRAs and why this is bad news for many Americans.
What is the SECURE Act?
SECURE stands for Setting Every Community Up for Retirement Enhancement. It was passed in the House by a 417-3 vote. However, it’s being held up by three Republicans in the Senate. Obviously, the bill has lots of support, although if it gets passed before year-end is anyone’s guess. Those in favor are confident of the bills passage.
Here are the major positives of the bill:
- Multiple Employer Plans (MEP) will be more accessible for small business owners. No longer will businesses need to be in the same industry to pool together 401(k) plans. Further, the “one bad apple” rule will go by the wayside. This means if one company messes up, it will not disqualify the entire plan.
- The start-up credit for new, small businesses will increase as well.
- Part-time workers will no longer be excluded from most 401(k) plans. They will only need one year of 1,000 hours or three years of 500 hours to be eligible.
- The age restriction for contributing to a traditional IRA will be eliminated. Currently, you cannot contribute to an IRA once you reach age 70 1/2.
- The age when you must begin required minimum distributions will be pushed back to 72 from 70 1/2. Savers can now delay withdrawals so their money can continue to grow unhindered for another year and a half.
- There will now be penalty-free withdrawals when you have a child, either through birth or adoption.
Check This Out: SECURE Act & its Impact on Self-Directed Plans
What is the Stretch IRA?
There’s one provision that have smart savers up in arms that concerns the Stretch IRA. The term, “Stretch IRA,” won’t be found in the tax code. Instead, it describes a strategy that many people use as an estate planning tool. It’s all about who your IRA beneficiary is. When you name you spouse as the beneficiary, he or she can assume your IRA when you pass. Essentially, your IRA will then become your spouse’s IRA and he or she will follow normal IRA rules.
However, if your IRA beneficiary is a non-spouse (i.e. your child), he or she has different rules. They would not assume the IRA as their own. Instead, they must start taking distributions. Currently, distributions can be taken throughout the beneficiary’s lifetime. This is why an IRA may be left to the youngest child. The required distributions are based on life expectancy. Therefore, the younger you are, the smaller the distribution will be. This allows more funds to stay in the plan and continue to grow at a greater pace than someone who is older.
The “stretch” comes in when your beneficiary can then leave the IRA to his or her child. Again, the same rules will apply with distributions starting at an early age. The account may continue to grow for generations. Typically, this strategy is used by wealthier people who do not need their retirement funds to live off of. However, most Americans can benefit from this idea. In fact, if you have a Roth IRA to leave your child, he or she will not even be taxed on the distributions!
What is Changing?
One provision of the SECURE Act is the way the Stretch IRA would work. Current rules would still apply to spousal beneficiaries. However, non-spousal beneficiaries will have ten years to distribute the entire IRA. There are some exceptions to this rule. These are considered “eligible designated beneficiaries”:
- A child under the age of majority
- Disabled or chronically ill
- Any other person who is not more than 10 years younger than the IRA owner
For example, if you left your IRA to your 14 year old son, he does not need to take mandatory distributions until age 18. At that point, he will have ten years to withdraw all funds. This is much different than the decades he would have to take distributions from the plan. Further, there will be no way to leave the IRA to the next generation.
Lawmakers say that an IRA is intended for the owner’s benefit, not as a tool to pass on wealth to your descendants. However, many people feel that they are being gypped if these rules are indeed enacted. Not only will the IRA be depleted, but, in the case of a traditional plan, taxes will be due much sooner and the bill may be greater.
What Can You Do?
Aside from splurging your IRA savings on yourself, your best option is to convert all traditional funds to a Roth IRA. Assuming you don’t need the funds and your wish is to pass it on, you can pay the taxes on any amount converted to a Roth. By converting, your beneficiary would not have to pay taxes on qualified Roth IRA distributions.
Though the rules of the SECURE Act will change how a Roth Stretch IRA must be withdrawn, at least your heir won’t be hit with large tax hits. Regardless, Roth IRAs are the better choice to leave to your loved ones. Estate planning may forever change if and when the SECURE Act passes.
Stretch IRA – The Final Verdict
Assuming the SECURE Act manages to get through the Senate, it’ll be very good for Americans. The pros of the legislature far outnumber the cons. On the other hand, if you were counting on the Stretch IRA, you may think otherwise. It can still be used as a solid estate planning tool. Utilizing the Roth option is still your best bet in our opinion.