Commentators appear to be almost uniform in proclaiming the demise of so-called stretch IRA and other defined contributions plan benefits (including 401Ks) after the Further Consolidated Appropriations Act of 2020 (FCAA). Whereas prior to 2020 designated beneficiaries could defer receipt of IRA and other defined contribution plan benefits over their lifetimes, the new rule places a ceiling of 10 years on this deferral.

For example, with certain exceptions including a surviving spouse, a designated beneficiary having a 30-year life expectancy, who previously could have deferred receipt of the 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. Note that under the new law there is no requirement that the IRA, etc., funds be withdrawn under any set schedule during the 10 years, as long as they are all withdrawn within 10 years. [See new IRC Section 401(a)(9)(H)(i)].

Nature Of The Problem

The two-fold concern created by the new tax law is that not only must all of the tax on the IRA, etc., be paid much earlier than in the past, but the tax rate on the receipts will likely be much higher than in the past, due to the bunching of income during a period when the recipients are likely to be in their peak earning years.

Take, for example, this typical fact pattern involving the new tax law versus the old:

• Assume a $1,000,000 IRA at the time of the account owner’s death.

• Assume a 5% growth/income rate.

• Assume a 60-year-old designated beneficiary, who lives the expected 25 more years.

• Assume a 40% combined federal and state income tax rate on a lump sum IRA distribution in year 10 after the owner’s death, under new law.

• Assume a 35% combined income tax rate if the designated beneficiary elects to take equal IRAs distributions over years 1 through 10 after the account owner’s death.

• Assume a 30% combined income tax rate on annual IRA distributions, under the old law, I.e., because the designated beneficiary will typically not always be in his or her peak earning years, and because the benefits are paid over 25 years.

• Assume a 20% combined income tax rate on the income generated by withdrawn funds invested outside of the IRA.

Income tax results to the designated beneficiary under the new law:

• Assuming the designated beneficiary elects to take equal payments over 10 years, the payments would be $82,731 (based on a standard amortization table, at 5%). After 25 years, these payments would grow to $1,854,391, after-tax.

• Assuming the designated beneficiary waits until the end of year 10 to take the IRA balance, the after-tax amount after 25 years will be $1,760,242, or approximately 5% less than the strategy of spreading the IRA distributions equally over 10 years.

Income tax results to the designated beneficiary under the old law:

• Under the old law, if the designated beneficiary took only the required minimum distributions over his or her 25-year life expectancy under the IRS tables, the after-tax value of the IRA distributions at the designated beneficiary’s age 85 would be $2,204,122. This is about 19% more than the best scenario under the new law, spreading out payments even further at an even lower income tax rate obviously being the difference.

Planning Alternatives

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

1. Take larger IRA distributions during lifetime. The theory here is to withdraw significant additional penalty-free amounts from the IRA, etc., during the owner’s lifetime, so that they will hopefully be taxed at a lower income tax rate than the beneficiary would otherwise pay, with the net after-tax funds then reinvested either in a Roth IRA or in other assets which will receive a stepped-up income tax basis at death. Does this plan make sense?

Let’s assume the combined federal and state income tax rate to 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 the combined tax rate on the investments which are purchased with the after-tax withdrawals is only 20%. (Remember the tax rate on capital gains can be as little as 0%, to the extent the beneficiary holds investments until death.) The numbers can be run a variety of different ways, but in general paying income taxes early, and at a significantly higher income tax rate than the account owner would have paid if he or she had maximized the income tax deferral available during his or her lifetime, is, unfortunately, not going to make a lot of mathematical sense in most situations.

In some scenarios this strategy can actually reduce the after-tax amount ultimately available to the client and his or her family. The reasons for this are that the client is accelerating the income tax payable during his or her life, at a significantly higher income tax rate, and is not taking advantage of the full 10-year income tax deferral after his or her death, under the new tax law. If the owner has not reached his or her required beginning date, the negatives associated with accelerating taxable IRA withdrawals could be compounded by this strategy.

Prior to doing any Roth conversion in order to minimize income taxes to the designated beneficiaries after the account owner’s death, the planner must be mindful of the various potential negative aspects of the Roth conversion, including such negative factors as: (i) the likely significantly higher income tax rate payable by the owner under a Roth conversion, versus taking minimum RMDs during life, and the time value of the taxes saved by not converting; (ii) the taxable growth in the after-tax RMDs can be controlled, and in any event the growth will receive a stepped-up income tax basis at the death of the account owner, thus eliminating all income taxes on this growth up until the time of the account owner’s death; (iii) only 10 years of tax-free Roth deferral after the account owner’s death are permitted under the new law, thus undermining the post-death tax benefits available to Roth IRAs under the old tax law; and (iv) the IRA owner may need to use the IRA funds themselves to pay the conversion tax, and therefore be converting much less than the entirety of the IRA distribution.

Another early withdrawal option which may produce significant income tax saving benefits would be to apply an “amortization approach” to the withdrawals. Under this plan, beginning at age 72 or later, when RMDs are required, the account owner can determine his or her (or joint, if married) approximate life expectancy, and then take withdrawals over this period plus 10 years.

For example, if a couple both age 72 and retired, feels their joint life expectancy is approximately 15 years, they could withdraw their account assuming a 25-year amortization table and a five percent interest rate, with the designated beneficiaries making any annual withdrawals the couple did not take during their lifetime. The only modification to this plan would be for the designated beneficiaries to defer withdrawing all or some the balance until after they retire but within the 10-year window, if this step will lower their overall taxes.

The major difference between the amortization approach during the couple’s lifetime and a plan of just taking RMDs is that the withdrawals will be slightly greater in the earlier years and slightly less in the later years, which in turn will hopefully create a smoothing out of taxable income at lower tax brackets. The goal of this plan is to reduce the income tax rate at which the withdrawals will be taxed each year by avoiding a large bunching of income during the working years of the couple and/or of their designated beneficiaries. Annual distributions during the account owner’s lifetime which exceed his or her RMD amount can be rolled into a Roth IRA, if desired.

2. Pay all or part of the IRA portion of your estate to lower income tax bracket beneficiaries. The theory here is that, if we have to live with the new tax law, at least minimize its effects by planning our estates in a tax sensitive manner. Assume, for example, that a client has four children, two in high income tax brackets and two not. Why not consider leaving the IRA portion of the client’s estate to the children in lower income tax brackets, with the basis stepped-up assets to the others? Of course, a drafting adjustment should be made for the fact that the lower tax bracket children will be receiving taxable income, whereas the others will not be.

This plan can be taken a step further if the client is interested in leaving a portion of his or her estate to grandchildren and/or great grandchildren, who may be in lower income tax brackets than the children (subject, of course, to the Kiddie tax). Just because an existing plan to defer income tax on IRA assets over the lifetime of grandchildren and/or great grandchildren will no longer be possible, does not mean distributions to grandchildren and/or great grandchildren in lower tax brackets (and who are usually also more in number than children, thus spreading the income over more taxpayers) is not a beneficial income tax planning technique, due to the lower overall income taxes which may often result.

Finally, of course any charitable gift will want to first be made out of the IRA, etc., portion of the client’s estate. If carefully implemented, this type of estate planning can definitely make sense.

3. Withdraw additional IRA funds early and use the after-tax amount to purchase income tax-free life and/or long-term care insurance. This option is intended to combine options 1 and 2, above, but rather than withdrawing all or most of the IRA funds early, the technique merely “freezes” the current value of the IRA by withdrawing only the growth in the same or the RMD, whichever is greater, hopefully without increasing the account owner’s income tax bracket. All or a portion of the after-tax withdrawals are then reinvested in income tax-free life insurance, including so-called second-to-die life insurance which pays only at the death of both spouses, and is therefore cheaper than an individual policy insuring only one spouse.

The life insurance can then be left to the beneficiaries who are in the higher income tax brackets, with the balance of the IRA left to those in the lower tax brackets, including, if desired, grandchildren and great grandchildren (again, of course with any adjustments desired to account for the disparate income tax treatment of the beneficiaries, and with due regard being given for the Kiddie tax).

Another option is to utilize the after-tax withdrawn funds to purchase long-term care insurance (including a hybrid life/long-term care insurance policy), in order to protect the portion of the IRA which has not been withdrawn, and potentially create an income tax deduction for premiums which are paid on a traditional long-term care insurance policy (including a so-called “partnership program” traditional long-term care insurance policy).

Again, if carefully implemented, this type of planning, which combines some elements from alternatives 1 and 2, above, can be beneficial.

4. Pay IRA benefits to income tax-exempt charitable remainder trust. This alternative technique involves designating an income tax-exempt charitable remainder trust as the beneficiary of the IRA proceeds. Assume, for example, a $100 IRA is made payable to a charitable remainder unitrust which pays the owner’s three children (ages 60, 58 and 56), or the survivors or survivor of them, 7.5% of the value of the trust corpus (determined annually) each year, until the last of the three children die. Assume this is 30 years, and that the trust grows at the same 7.5% annual rate throughout the 30 years. Under this plan, the owner’s children will receive a total of $7.5 a year (or $5 after an assumed 33.3% combined federal and state ordinary income tax rate) each year, which when then compounded outside of the trust, at a rate of 6% after 20% capital gains tax rate, will equal almost $400 in 30 years. The charity will receive the $100 principal at the end of the 30 years, and the trust meets the requirements of a qualified charitable remainder unitrust.

This sounds good, but compare this alternative to the alternative of doing no planning under the new tax law. The $100 IRA would grow to $206 10 years after the owner’s death. Assuming a 40% tax rate on this amount compressed during the children’s peak earning years, this would net them $124 10 years after the owner’s death. Next assume this amount grows at a 7.5% rate (or 6% net of an assumed 20% capital gains tax rate) for the next 20 years. Similar to the charitable trust alternative, the children would net almost $400. The difference is that charity does not receive $100 under this no planning scenario. Perhaps more significantly, however, under the no planning alternative the entirety of the IRA funds is available to the children, at all times, whereas under the charitable remainder trust alternative the principal of the trust may not be accessed until paid out to the children according to the designated schedule.

Paying IRA, Etc., Funds To Trusts After The FCAA

Does paying IRA, etc., funds to trusts after the death of the account owner, to protect the funds for the beneficiary, including protection against lawsuits, divorce, and estate taxes, still make sense under the new law? Many will argue it does not, because of the high income tax rates on trusts.

Recall, however, that the high income tax rates on trusts can be addressed through the judicious use of Section 678 of the Internal Revenue Code in the drafting of the trust, which causes the income of the trust to be taxed at the beneficiary’s income tax rates, and not the trust’s rates. Limiting this withdrawal right to 5% of the trust annually will not only eliminate any potential adverse estate or gift tax consequences, but in most states will also eliminate any potential asset protection issues on the annual lapsed withdrawal rights.

The issue, then, is how to address income amounts which may exceed 5% of the value of the trust (including non-IRA assets). Perhaps the best technique will be to allow the trustee to spray these amounts among the designated beneficiary and his or her children, in an effort to lower the overall income taxes on the IRA distributions. If the trustee is also a permissible beneficiary of this spray amount, his or her spray power must be limited by an ascertainable standard when it comes to distributions to himself or herself, in order to avoid potential adverse tax and creditor consequences. An independent trustee can also be given a spray power over income not subject to the Section 678 withdrawal right, without the need for an ascertainable standard.

Note that the above discussion refers to the so-called “accumulation trust” approach to planning for IRA, etc., payments to trusts on a “stretch” basis. It will not work in the case of a so-called “conduit trust,” because conduit trusts mandate that all IRA and plan distributions be paid to the designated beneficiary of the trust, upon receipt. Very few clients are likely to opt for a conduit trust approach when it comes to trusts for grandchildren, however, so paying IRA, etc., benefits to accumulation trusts for grandchildren should normally continue to be the recommended course, going forward.

Note also that existing “accumulation trusts” may need to be modified in light of the new law, in order to ensure the 10-year deferral period for payments to a “designated beneficiary” is achieved over the 50% shorter 5-year default period. The key language for the drafting attorney to focus on is found in Regs. Section 1.401(a)(9)-4, A-1:

“A designated beneficiary need not be specified by name in the plan or by the employee to the plan in order to be a designated beneficiary so long as the individual who is to be the beneficiary is identifiable under the plan. The members of a class of beneficiaries capable of expansion or contraction will be treated as being identifiable if it possible to identify the class member with the shortest life expectancy.”

For example, if the trust includes a testamentary power of appointment to the surviving spouse of the beneficiary, with no age limit on the beneficiary’s surviving spouse, the trust will not qualify as a designated beneficiary because it is impossible to identify the class member with the shortest life expectancy.

Some Final Thoughts

Which of the above options will work best in a given situation will depend on all the facts and circumstances. What is important to note here is that the options can be combined, if desired, to produce maximum benefits. For example, the “amortization approach” option outlined under heading 1, above, can be combined with the estate plan described under heading 2, above, which lowers overall income taxes by leaving the IRA-type assets to the lower income tax bracket members of the family, and/or with the life insurance and long-term care insurance options described under heading 3, above.

James G. Blase, CPA, JD, LLM, is founder of Blase & Associates LLC, a St. Louis-area law firm practicing primarily in estate planning, tax, elder care, asset protection, and probate and trust administration. Mr. Blase is also an adjunct professor in the Villanova University Charles Widger School of Law Graduate Tax Program.