The Setting Every Community Up for Retirement Enhancement (SECURE) Act was enacted as part of a broader appropriations bill on December 20, 2019. In addition to showing the country to which lengths the legislature will go to create a marketable acronym, the Act made some big changes to how families will pass retirement funds to the next generation.
True to its name, the Act was created to make some common-sense changes to the way Americans save for retirement. This includes reducing the costs of setting up retirement plans for small employers, removing restrictions from contributing to IRA accounts after age 70 ½, and extending the age at which retirees must begin withdrawing money to age 72 (rather than the previously required age of 70 ½). To help pay for these changes, the Act changed the way that family members will inherit these funds when the account owner dies.
When an IRA is inherited by the pay-on-death beneficiary you designate on your IRA account, that person has the option of withdrawing the entire balance, any time they want. That beneficiary will pay income tax on any withdrawals; withdrawing a large amount will of course entail claiming more taxable income, and paying more income tax. Alternatively, the beneficiary may choose to withdraw only a minimal amount … an amount calculated annually based on life expectancy tables. This amount is call the Required Minimum Distribution, or RMD. Similar to how you will be required to begin taking these minimal distributions at age 72 (under the Act), people who inherit these funds must begin taking out RMDs immediately.
Under the former rules, the beneficiary could take these RMDs annually over the course of their lifetime. This would allow that beneficiary to maximize continued tax-deferred growth; much as your retirement account has grown tax-deferred over your working career, the IRA account could continue to grow tax-deferred over the course of your child’s life, minus the required minimum distributions. An IRA inherited by someone who chooses to take out only these RMDs is called a stretch IRA, because that person chooses to stretch the withdrawals and tax deferral over the course of his or her lifetime.
Under the new Act, this option to take lifetime withdrawals has ended for most beneficiaries. RMDs are still an option for IRA funds inherited by spouses, minor children, or disabled children; for all others, the entire account must now be withdrawn within ten years of the death of the account owner.
For many families, this won’t change much. The majority of an IRA was likely going to be spent down anyway, and the token amount left was going to pass on to the children who were likely going to withdraw it regardless of tax consequences. But for some families, the ability to stretch the IRA out over the life of their family members’ lives was key to their financial and estate plan.
Consider the case of a child whose parents have concerns about substance abuse or gambling, or a child who has never shown themselves to be responsible with large sums of money. A common practice was to create a trust for this child that would receive the IRA moneys on behalf of that child for the child’s lifetime via these stretch rules; the trustee of the trust would make distributions as needed to that child, subject to important IRA restrictions within the trust document. By only taking small distributions from the IRA each year, the trustee was able to minimize the tax impact over a very long period of time while maintaining control of the money.
Now, the trustee must take out the entire IRA within a ten year period and pay taxes on a larger share of the trust proceeds (IRA distributions are taxed at either the trust’s tax rate or the tax rate of the trust’s beneficiary, depending on how the trust is structured). These trusts have lost the ability to slowly spend down the IRA account over the child’s lifetime.
To be fair, IRAs were never meant to be inheritance vehicles; the government allows workers to sock away money and to deduct these contributions. The funds are allowed to further grow tax deferred; in retirement, the logic goes, the worker will withdraw this larger sum, paying tax slowly over their retirement years. What little money left that goes to that worker’s children would likely be withdrawn and taxed accordingly.
Of course, where there are tax benefits, there are those who wish to maximize them. For a country whose retirement assets are primarily held in these types of accounts, large sums could be passed on to children knowing there would be continued tax advantages. That is no longer the case for most legacy plans.
WAYS TO PASS ON TAX-DEFERRED WEALTH
So, with the new rules and the loss of the stretch IRA for most families, what are the best ways to pass on this tax-deferred wealth? I see the following options becoming more popular:
ROTH Conversions. You have always had the ability to convert your tax-deferred IRA (a “traditional” IRA) into an IRA that will grow and be distributed tax-free (a Roth IRA). The catch is that you will pay tax on the amount you choose to convert in the year in which you convert it . . . convert $50,000 from an traditional IRA into a ROTH IRA will add $50,000 to your income for the year and will increase your associated tax liability. When the people inheriting your IRA are in a higher tax bracket and would therefore pay more tax than you would during the conversion process, this can be a very attractive option (you take the tax “hit” at your lower tax bracket so they don’t have to). The people inheriting the new Roth IRA will still have to drain the account over a ten-year period, but they will do so income tax-free.
Life Insurance. If you are funding a trust with your IRA money and you know that the accelerated payout will cause a substantial loss in account value once taxes are taken, it may be worthwhile to consider a permanent life insurance policy to partially fund this trust and to make up the difference. The RMDs you are taking from your IRA, if not otherwise needed, could be used to help fund this policy. Consider also leaving IRA money to charities and funding an inheritance with the proceeds from life insurance or other assets, such as the proceeds from the sale of a home.
Charitable Remainder Trusts. Though fairly expensive to create with an attorney (as well as having some ongoing administrative expenses, such as annual tax filings), there are trusts that can accept your IRA money completely tax free. The trust creates a payout stream to your beneficiary . . . usually 5% per year or so, for up to twenty years. At the death of the beneficiary (or at the end of a twenty years), the trust pays the remaining assets to the charity of your choice. Of course, this is only appropriate for those who are charitably inclined!
Speaking of charitably inclined, remember, charities do not pay tax on gifts from IRAs. If you are planning on giving some money to charity anyway, consider giving some or all of your IRA money and leaving other assets, such as proceeds from the sale of real estate, life insurance, etcetera, to your beneficiaries.
Review your IRA beneficiaries. For spouses, disabled children, and trusts for minor children (that is, your own children, not grandchildren), you may not have much to change. If you are comfortable with your beneficiaries receiving money over a ten-year period, you may also not have much to change. For those who wish to use IRA money for a lifetime income stream for non-spouse beneficiaries, you may want to consider a more elaborate solution such as a Roth conversion or charitable remainder trust. As always, you should consult with your tax professional before making any big moves that can affect your tax liability.
If you have a trust set up for your family, review it. From strictly a tax-standpoint, your trust is “safer” if IRA distributions pass directly from the IRA, through the trust, and outright to the trust’s beneficiary (this is because trust tax rates are much higher than individual rates; it is better that these taxable distributions end up in the hands of an individual, and not a trust, whenever possible). If you do not wish for this to be the case, your trust may need some changes. The new default is that spouses and disabled children can stretch distributions out over their lives, as can certain beneficiaries who are very close to your age. Minor children (not grandchildren) can take small RMD amounts until age 18, at which point the remaining balance must be withdrawn over the next ten years (by age 28).
Remember, your $1 million IRA is not really worth $1 million; it is worth $1 million minus any tax liability that would be owned by those making withdrawals . . . this could mean your estate takes a 40% cut (or more) when you factor in federal and state income taxes, depending on your plan. Your investment, tax, and legal professionals are a great team and can help you to make sure the right things get to the right people, the right time, the right way. Consult with a qualified attorney when it comes to your estate plan; your family will thank you.