The Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law by President Trump on December 20, 2019, as part of funding legislation for the federal government, has many provisions relating to financial planning, especially retirement planning with IRAs and employer-sponsored plans. Among the provisions attracting the most attention is the curtailing of “stretched” inherited retirement assets.
In a typical stretch arrangement, one spouse would retire with a retirement account, which would be tapped during their lifetime and the balance left to a surviving spouse. The surviving spouse would continue to draw down the account and eventually leave the remaining funds to their children (or other beneficiaries, such as grandchildren). These ultimate heirs might be able to spread required minimum distributions (RMD) over their life expectancies, possibly resulting in decades of untaxed compounding and substantial wealth accumulation.
The stretch still applies in limited cases; broadly speaking, while the SECURE Act eliminates the stretch for most beneficiaries, it keeps the stretch opportunity intact for the plan participant’s surviving spouse. In addition, disabled and chronically ill beneficiaries can still stretch RMDs, and so can minors until they come of age. Other beneficiaries not more than 10 years younger than the plan participant (perhaps siblings or cohabitants) can also continue to stretch RMDs.
Moreover, the IRS recently released new life expectancy tables for distributions beginning in 2021, which these “eligible designated beneficiaries” eventually will be able to use; the Exhibit contains selected examples from these tables. For example, someone who died in 2019 would leave a surviving spouse, age 70, an IRA with RMDs of 17.0 years on the old life expectancy table, while the same person dying in 2021 or later will leave a surviving spouse, age 70, an IRA with RMDs of 18.7 years on the new table. The longer life expectancy would mean fewer RMDs each year, a potentially smaller tax on those RMDs, and more funds left in the IRA for continued compounding.
Selected Single Life Expectancies, In Years (For Use by Beneficiaries)
The 10-year Hitch
The ability to extend tax deferral within an IRA for, as an example, 20 or 30 years was a potential boon to beneficiaries, so many estate plans included this stretching of retirement account distributions. Under the SECURE Act, only selected beneficiaries will have this ability. In many families, when an IRA or a qualified plan passes to a younger relative, the account must be depleted within 10 years after the account owner’s death.
Suppose 45-year-old Denise inherits the IRA that passes down from her mother, Claire, after Claire’s death in 2020. Denise will not have annual RMDs, but she will need to withdraw all of the money in the account by December 31, 2030, the end of the 10th calendar year after Claire’s death. In 10 years, Denise will be 55, perhaps at the height of her career earnings. If she waited the full 10 years and then withdrew the full balance of the IRA, she would be adding full distributions from a six- or seven-figure IRA and would generate steep income taxes for that year. Alternatively, Denise could withdraw some or all of the balance each year as long as the full balance is withdrawn by the end of the 10th calendar year after Claire’s death. In sum, the SECURE Act will have an impact on the estate plans of many clients who name a descendant as IRA beneficiary.
The SECURE Act applies to the retirement accounts of individuals who die in 2020 and later years. The accounts of people who already had died before 2020 are still covered by the old rules—until the beneficiary has died, when the new rules take effect.
For example, consider that Wendy died in 2016 and left her IRA to her daughter Vicki, who has been taking RMDs based on her own life expectancy. Vicki can continue to follow that schedule. Further suppose that Vicki dies in 2021 and her son Tim is the successor beneficiary of this IRA. In this scenario, Tim will be subject to the SECURE Act’s 10-year rule and will have to withdraw the remaining balance of this inherited IRA no later than December 31, 2031.
For advisors, the challenge will be to maximize the allowable tax deferral for affected clients without running afoul of the new rules. One key step is to have all clients review their beneficiary designations for IRAs and qualified plans. Will the SECURE Act have a major impact? If so, what can planners do? Perhaps IRAs might be left to disabled or chronically ill beneficiaries, while other heirs receive different assets from the decedent.
The Roth Response
For many clients, one possible planning tactic is to focus on converting traditional IRA dollars to Roth IRA dollars. Such conversions generate current income tax, so clients may need to be persuaded to act on this suggestion. One point to consider is that the federal current tax rates are relatively low, and scheduled to remain in place through 2025. That can be especially beneficial for married couples filing joint tax returns.
For example, in 2020 such couples can have taxable income, after deductions, of up to $78,950 and stay within the 12% bracket. The 22% bracket goes up to $168,400 of taxable income, and the 24% bracket to $321,450. A married couple might have $150,000 in adjusted gross income but less than $130,000 in taxable income after taking the standard deduction ($24,800 on joint returns in 2020); this couple could then convert $35,000 from their traditional IRAs to Roth IRAs and owe only $7,700 in added federal income tax (22% of $35,000). Such moves could be made every year, with careful planning to stay within lower tax brackets. Over time, the traditional IRA balance would fall, while the Roth balance would increase.
To encourage paying an extra $7,700 or so in tax each year, advisors could point out that Roth IRA owners never have RMDs at any age. After the age-59½ and five-year thresholds have been passed, all Roth IRA distributions are tax-free, so these accounts would provide a source of untaxed cash in retirement, if needed. If cash is not needed, any Roth IRA earnings could compound, potentially tax-free. Roth IRA money accumulated at the first spouse’s death could be left to the surviving spouse, who would not face the 10-year deadline for complete IRA distribution, thus continuing the tax-free buildup.
At the surviving spouse’s death, Roth IRA money could be left to children or grandchildren if they are named as the account beneficiaries. The 10-year deadline would then go into effect (unless the beneficiary meets one of the special cases discussed above), assuming the SECURE Act is still existing law. Again, all distributions after the five-year threshold has been met would be tax-free, regardless of the beneficiary’s age.
Under these assumptions, this stretching of Roth IRA accumulation would end after 10 more years have passed, and all money would have to be withdrawn by the younger beneficiaries by that point. This acceleration of Roth IRA distributions would not, however, create taxable income. Regardless of the amount involved, the ages of the beneficiaries, or those beneficiaries’ future tax brackets, the distributions would avoid income taxation.
Moreover, a succession of annual Roth IRA conversions would reduce clients’ traditional IRA values. By the time such clients reach age 72 and must begin annual RMDs under the new rules, those RMDs from the traditional IRA would be smaller, and the resulting tax bills would be lower.
In effect, this plan shifts money from traditional IRAs to Roth IRAs at a controlled tax cost each year. By the time the IRA money moves to younger relatives, there will be fewer traditional IRA dollars to be taxed before the end of the 10-year period, and more Roth IRA dollars, which will be tax free.
Pursuing Insurance Policies
Another possible strategy to maintain wealth across generations would be for clients to withdraw money from their traditional IRA each year while they are in low-to-moderate tax brackets, as explained above. The after-tax proceeds from the money withdrawn could be used to pay life insurance premiums on the IRA owner, assuming he is insurable, with the policy payable to younger relatives.
Those death benefits will eventually go to the beneficiary or beneficiaries free of income tax and with no risk of running afoul of the IRA distribution rules. This payout can help offset the potential loss from a no-longer-available long-term stretch IRA.
If estate taxes are a concern, the insurance policy might be held by an irrevocable life insurance trust, and thus kept out of the IRA owner’s estate. Indeed, the use of trusts may be another way to work around the loss of stretch IRAs, as will be explained in a future Tax Tips article.