The stretch IRA is under siege.
If it’s eliminated, a non-spouse beneficiary of an IRA will be required to pay income taxes on the entire inherited IRA within five years of the IRA owner’s death. Here are two promising solutions using tax-free income that your clients can act on before the law changes. Let’s discuss Roth IRA conversions and life insurance.
Roth IRA Conversions
A majority of IRA and financial experts whom I’ve interviewed believe Roth IRA conversions deserve serious consideration in the big-picture analysis of a client’s financial strategy.
Unfortunately, the proposed legislation also has Roth IRAs in its sights. Under the proposed law, a Roth IRA left to a non-spouse beneficiary will have to be liquidated within five years of the owner’s death. The good news is that this liquidation isn’t taxed. The money in the inherited Roth IRA becomes plain old after-tax dollars. The basis for the distributed property or money will be the account’s fair market value as of the liquidation date.
If your client begins making a series of Roth IRA conversions now, the converted amounts will grow income tax-free for as long as the money remains in the Roth. That could be for the rest of your client’s and their spouse’s lives, and under the proposed rules, for as long as five years after their deaths. And, unlike traditional IRAs, Roth IRAs aren’t subject to required minimum distributions while the owner and spouse are living. A series of Roth conversions can also benefit the second generation: The children will pay less income tax on the inherited IRA distributions because the balance will have been reduced by the amount that was converted.
A Roth conversion may also reduce federal or state estate taxes. By making a Roth conversion, you’re effectively getting the income tax out of the taxable estate. Let’s assume that: (1) your client has a traditional IRA worth $1 million and $280,000 in other non-IRA after-tax dollars, and (2) the tax on conversion and the client’s tax bracket is 28 percent. If they don’t make a Roth conversion, the entire value of the IRA and after-tax dollars ($1.28 million) will be included in the taxable estate. On the other hand, if they convert the $1 million traditional IRA to a Roth IRA and use the $280,000 after-tax dollars to pay the tax, the taxable estate will only be $1 million. (Let’s forget about growth on the account and the ability to convert at 28 percent for the moment.) In both scenarios, your client’s initial purchasing power remains the same ($1 million). The difference is that after the conversion, the Roth grows tax-free, but the growth in the traditional IRA and the after-tax investments are taxable.
Finally, what if the new law is never passed or your client dies before it’s passed? The advantages of a well thought-out Roth IRA conversion strategy are still generally advantageous to many IRA owners and their heirs.
Life Insurance Options
From an income tax perspective, life insurance has more in common with Roth IRAs than many people realize. If your client does a Roth IRA conversion, they must voluntarily pay income tax before they’re required to in order to receive a Roth IRA, which then grows tax-free. If your client pays for life insurance premiums by making taxable withdrawals from a traditional IRA, they voluntarily pay income tax before they have to in order to receive an asset that will be tax-free to their beneficiaries—their life insurance.
With the existing law, recommending the combination of stretch IRAs and second-to-die life insurance (the same concept could be applied to other types of life insurance) is like recommending peas and carrots; they just work well together. We frequently recommend purchasing a second-to-die life insurance policy and including disclaimer provisions in the beneficiary designation of the IRA. The spouse is the primary beneficiary of the IRA and the children equally are the first contingent beneficiaries. The grandchildren (or trusts for the benefit of grandchildren) are the second contingent beneficiaries. The spouse is given the option to keep or disclaim the IRA to the children. Each child is given the choice to keep or disclaim their portion to their children.
If the law doesn’t change, after both spouses die, the children would be more likely to disclaim the IRAs because the grandchildren will get a long “stretch,” and the children could keep the life insurance proceeds. If the law does change, the children would be far less motivated to disclaim the inherited IRA because the grandchildren would have to pay income taxes on it within five years of the IRA owner’s death. Regardless of what happens to the law, a second-to-die policy can provide tremendous flexibility for your clients’ heirs.
If your client’s children are doomed to forgo the stretch, Roth IRA conversions and life insurance, or preferably some combination of the above, may significantly add to your client’s legacy.
This is an abbreviated version of the author’s original article in the March issue of Trusts & Estates.