Commentators appear to be almost uniform in proclaiming the demise of so-called stretch IRAs and other defined contribution plan benefits, including 401(k)s, after the Further Consolidated Appropriations Act of 2020 (FCAA) was signed in December. Before 2020, designated beneficiaries could put off receiving benefits from IRAs and other defined contribution plans and stretch them out over their lifetimes. The new rule, however, says the benefits have to be paid out and done in 10 years.

For example, with certain exceptions (including those for a surviving spouses) a designated beneficiary having a 30-year life expectancy who previously could have delayed receiving IRA or plan benefits over 30 years must now fully withdraw the benefits within 10 years of the plan participant’s or IRA owner’s death. There is no set schedule for distributing the funds during those 10 years, as long as they are all withdrawn by the end.

The Nature Of The Problem
Under the new law, not only must all of the tax on IRAs and plans benefits be paid much earlier than it was before, but the rate will likely be much higher too, since that income will be bundled into recipients’ peak earning years.

Let’s take an example of how the new law changes things. Let’s say we have an IRA owner who dies and leaves a $1 million IRA. The designated beneficiary is 60 years old and expected to live another 25 years. We assume the IRA’s income/growth rate is 5%. We’re also assuming there’s a 20% combined income tax rate on the income generated by withdrawn funds invested outside of the IRA.

Under the old law, if the beneficiary took only the required minimum distributions over his or her 25-year life expectancy, the after-tax value of the IRA distributions when the designated beneficiary was age 85 would be $2,204,122. (We’re assuming there’s a 30% combined federal and state tax rate since most of the income would not be in the beneficiary’s peak earning years.)

Now let’s look at what happens under the new law. If we assume that the beneficiary will take equal payments over 10 years, these payments would be $82,731 (based on a standard amortization table at 5% and a 35% combined federal and state income tax rate). Once removed from the taxable accounts, after 25 years the payments would grow to $1,854,391.

Now let’s assume the designated beneficiary waits until the end of year 10 to take the IRA balance. Here we assume there’s a 40% combined federal and state tax rate on the lump sum. The after-tax amount after 25 years would be $1,760,242, or approximately 5% less than the strategy of spreading the IRA distributions equally over 10 years.

The $2,204,122 result under the old law is about 19% more than the best scenario under the new law, since it spreads out payments even further at an even lower income tax rate.

Planning Alternatives
There are a number of alternatives the client can consider in order to dampen the new law’s tax effects. The major alternatives will be briefly explored and tested here:

1. Taking larger IRA distributions during the clients’ lifetimes. The theory here is to withdraw significant additional penalty-free amounts from IRAs, etc., during the account holder’s lifetime, so they will hopefully be taxed at a lower income rate than they would be otherwise, with the net after-tax funds then reinvested either in a Roth IRA or in other assets that will receive a stepped-up income tax basis when the owner dies.

Does this plan make sense? Let’s assume the combined federal and state income tax rate for the IRA owner or designated beneficiary on early withdrawals (by the account owner) and withdrawals under the new 10-year withdrawal rule (by the designated beneficiary) is 35%, but that there’s only a 20% combined federal and state tax rate on the investments purchased with the after-tax withdrawals. (Remember, the tax rate on capital gains could be as little as 0% if beneficiaries hold the investments until they die.) The numbers can be run a variety of different ways. But in general, in most situations, it won’t make sense mathematically to pay income taxes early—at significantly higher rates than you would have paid maximizing the income tax deferral available during your lifetime.

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