The Proposed Exclusion Amount to the Death of the Stretch IRA Complicates Planning.
This post is the eighth in a series about the Death of the Stretch IRA. If you’re a new visitor to my blog, this post might not make much sense to you unless you back up and read the preceding posts related this one. Those posts spell out the details of the proposed legislation that will cost your family a lot of money. This post discusses the proposed exclusion amount to the Death of the Stretch IRA legislation and explains how it will be applied to each IRA owner.
When I wrote my book, The Ultimate Retirement and Estate Plan for Your Million-Dollar IRA, I accurately predicted most of what the Senate Finance Committee is proposing to make law. The one point that I did not predict, though, was that each IRA owner would be permitted to exclude a portion of their retirement plans from the Death of the Stretch IRA legislation. I don’t know if it was the Committee’s attempt to make the legislation seem not as bad as it is, but it certainly makes things more complicated for individuals who are trying to design an effective estate plan. So I want to explain how the exclusion amount works.
The Exclusion Amount Applies to All Retirement Accounts
The whole idea behind the exclusion is that a certain portion of your IRAs and retirement plans would be protected from the Death of the Stretch IRA legislation. Most people would think, “That’s great! I’m going to apply my exclusion to my Roth IRA so that my beneficiaries can continue to enjoy the tax-free growth for the rest of their lifetimes.” Well, that’s not how the exclusion amount works. It has to be prorated between all of your retirement accounts. Let’s say that you die with $2 million in retirement plans – $1.5 million in your 401(k), $400,000 in a Roth IRA, and $100,000 in a Traditional IRA. Here’s how the exclusion amount would work. Your 401(k) accounts are 75 percent of your retirement plans, so 75 percent of the exclusion amount (or $337,500) of that would apply to that account. Your Roth IRA accounts are 20 percent, so 20 percent of the exclusion amount (or $90,000) would apply to that account. Your Traditional IRA accounts are 5 percent of your retirement plans, so 5 percent of the exclusion amount (or $22,500) would apply to it. The bottom line is that the exclusion amount has to be applied to all of your retirement accounts, both Traditional and Roth.
The Exclusion Amount Applies to All Non-Exempt Beneficiaries
I’m going to emphasize one subtle but very important point about the Death of the Stretch IRA and your beneficiaries. The legislation did provide that some beneficiaries are completely exempt from the new tax rules. For most of you, the most important exempt beneficiary is your spouse. You can leave $10 million in retirement plans to your spouse (although I’d prefer that you’d add disclaimer provisions for your children!), and he/she can still stretch them over the rest of his/her life. Disabled and chronically ill beneficiaries are exempt, as are minor children. Charities and charitable trusts are also considered exempt beneficiaries. Now that you know who is considered an exempt beneficiary, I want to talk about the beneficiaries who aren’t exempt. For most of you, it’s your adult children. If you have adult children who aren’t disabled or chronically ill, and you name them as beneficiaries on your retirement plans, the exclusion also has to be prorated between them. You may have preferred to leave the amount that was excluded from your Roth account – in the above example, $90,000 – to the child who would receive the most tax benefit from it, but that’s not how the exclusion amount works. If you have two children and they are named as equal beneficiaries, then each will receive (and can continue to stretch) 50 percent of the excluded amount– or $45,000. Both children would also receive $155,000 from the Roth that can’t be stretched, and the account would have to be withdrawn within five years. Granted, qualified withdrawals from Roth accounts aren’t taxed, but the greater cost is that the bulk of their Roth inheritance will no longer be permitted to grow tax-free.
Planning Opportunities Created by the Exclusion Amount
Oddly enough, there are certain planning opportunities created by the exclusion amount that is proposed in the Death of the Stretch IRA legislation. If you have a beneficiary who is exempt, then you should remember how the exclusion works. Suppose that you die with retirement plans that are worth $500,000 and you left 10 percent (or $50,000) to charity and the remainder to your child. In that case, none of your retirement plans would be subject to the Death of the Stretch IRA rules. That’s because the charity is an exempt beneficiary, so the $50,000 it received is exempt from the rules. And the remaining $450,000 that went to your child is within the permitted exclusion amount, so her inheritance can be stretched over her lifetime.
I predict that the proposed exclusion amount will create headaches for financial advisors across the country. Just imagine the chaos! Where your beneficiary might have inherited one IRA, now they’ll inherit two – and each will be subject to a different set of rules. How can they call this “simplified”?
Please stop back soon for my next post on this important legislation!
For more information on this topic, please visit our Death of the Stretch IRA resource.
P.S. Did you miss a video blog post? Here are the past video blog posts in this video series.