Most of you have probably heard about the SECURE (Setting Every Community Up for Retirement) Act. It was signed into law before Christmas and went into effect the first of this year. It contains some valuable elements that will help those saving for retirement, but it also did damage to some of the strategies used in long-term family wealth planning. We’d like to talk about a change that could alter literally every financial plan in existence up to now and change the way plans are crafted in the future. If you think we’re being hyperbolic, well… we’re not alone. The Director of Retirement Research at Carson Wealth said “[t]his is nothing short of a disaster for trust planning…”. A Marketwatch article contains the quote “[the Secure Act] is a complete disaster from a planning perspective…”. So what’s so bad in this bill? Well, nothing less than the death of the Stretch IRA.
Stretch IRAs were estate planning tools that extended the tax-deferred status on a traditional IRA when passed onto a non-spouse beneficiary. Now, the SECURE Act requires that inherited IRAs be completely drawn down within 10 years of inheritance. The new rules also apply to inherited 401(k) accounts.
Let’s use an example to demonstrate. Let’s say a 40-year-old son has just inherited a $1 million IRA from his parent. Under the previous rules, the son would have to take out Required Minimum Distributions (RMDs) that would factor in his age, life expectancy, and the value of the IRA, allowing him to live off the account for the rest of his life. Now, that has all been thrown out the window, and the IRA must be drained in ten years, no ifs, ands, or buts. So, in the best-case scenario, he’s withdrawing approximately $100,000 per year for ten years in the prime earning years of his life, causing a massive taxable event. It’s important to note that there aren’t any tax breaks for IRAs, inherited or not. This means distributions will be taxed as ordinary income at the beneficiary’s tax bracket. In the worst case, he won’t have access to the funds until year ten, at which point he must withdraw all of the funds, losing approximately half to taxes.
Before we expound upon the worst-case scenario, let’s pump the brakes. The good news is that if you had an inherited IRA before January 1, 2020, these new rules don’t apply to you. Also, there are some exceptions to the 10-year rule, such as inheritors that are eligible designated beneficiaries. These include:
- The surviving spouse of the deceased account owner,
- A minor child of the deceased account owner; when the minor reaches the age of majority, the account balance must be distributed within 10 years after that date,
- A beneficiary who is no more than 10 years younger than the deceased account owner, or
- A chronically ill individual
Outside of these exceptions, inheritors must liquidate inherited IRAs within a decade of their receipt.
The worst-case scenario, referred to above, would be when an individual designates a “conduit” or “pass-through” trust as beneficiary of what was a Stretch IRA. In this situation, the trust would dictate that the beneficiary only receives the RMD every year, no more, no less. But, as you’ll recall from earlier, there are no more annual RMDs, just one big one at the end of the decade. As such, an inheritor of such a trust would be locked out of their money until they had to take all of it in one fell swoop, paying probably the biggest tax bill of their life. These types of trusts were designed for folks who may be young or inexperienced with money and set them on a budget from which they could not deviate. Now, that budget is taken away and they are given one lump sum in a decade, practically the exact opposite of what the designer of the trust intended.
The motivations for this change in the law seem fairly straightforward – increased tax revenue. According to the Congressional Budget Office (CBO), changing the rules regarding Stretch IRAs will generate about $15.7 billion in tax revenue over the next decade. Overall the Secure Act is projected to generate $16.4 billion in tax revenue in the next ten years.
So, if you’re in this situation, what do you do? Well, anyone with an IRA trust needs to get it reevaluated as soon as possible so as to ensure that there are no damaging consequences that were unforeseen at the time of its drafting.
An important step to take if you’ve inherited an IRA is to time the distributions as best as you can. The goal of this process is to decrease the total tax burden on your distributions; you want to take as much as you can from the IRA when your taxes are as low as possible. So, if you’ve had a loss in a given year, it would make sense to distribute more of the IRA then, and vice versa with a gain. For individuals nearing retirement, they may want to hold off on any distributions until after retiring, when their income will surely decrease, precipitating a lower tax rate as well.
There are ways to achieve what was intended with the Stretch IRA; namely, providing lifetime income to a child or heir. One possible alternative is to use a charitable remainder trust with the child designated as the lifetime income beneficiary.
A Roth IRA conversion done before the account is bequeathed could help remedy this situation. Because a beneficiary taking distributions from a Roth IRA is typically not a taxable event, a strategic Roth IRA Conversion can maximize wealth and lower taxes in retirement for the retiree, as well as benefit the retiree’s heirs under the new 10-year distribution rules.
Another possible option, if the deceased IRA holder has a surviving spouse, is to split the primary beneficiary between surviving spouse and the son. When the spouse inherits, she can treat the IRA as her own and transfer it to her own account, as she is an Eligible Designated Beneficiary and not subject to the 10-year rule and will take RMDs as prescribed. The son will then take distributions on only a fraction of the original IRA, significantly lowering the tax burden. Then, upon the mother’s passing, the son will inherit her portion of the IRA. This process significantly increases the distribution period and allows for a lower tax bill.
Although the impact of the Secure Act won’t be felt for decades, the time to act is now. The CBO has projected a substantial increase in tax revenue, so it’s unlikely you can completely avoid the impacts of this, but with proper planning, you can mitigate the most impactful parts and maintain a stable and successful legacy.
About the Author: Mike Hengehold
Mike Hengehold is Founder and CEO of HCM Wealth Advisors. Mike holds the Personal Financial Planning Specialist designation from the American Institute of Certified Public Accountants and has more than 30 years of investment, tax and financial planning experience.