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November 4, 2020

The Stretch Is Dead: Estate Planning Options for IRA Accounts Post-SECURE Act

Please read important disclosures HERE.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law on December 20, 2019, dramatically changed the estate planning options available to individuals with assets held in IRAs.1 While the SECURE Act raised the age for required minimum distributions from retirement accounts to age 72, the act also limited the amount of time many non-spouse beneficiaries of an IRA have to deplete an IRA account to 10 years.

Before SECURE, most beneficiaries could take required minimum distributions from an inherited IRA over the beneficiary’s lifetime, thereby taking annual minimizing withdrawals to lessen the tax impact and letting the account grow tax-deferred over time.

After SECURE, most beneficiaries must close out an inherited IRA in 10 years, thereby realizing the income from a traditional IRA more rapidly and taking the tax hit sooner. The likely result is quicker depletion of the IRA and more of the inherited IRA dollars going to taxes, especially if the beneficiary is working during this time and is in a higher income tax bracket.

Tactics to Stretch IRA Distributions Under SECURE

Hope springs eternal. Even with the SECURE Act in place, there are still a handful of estate planning strategies that can potentially help maximize the financial benefits of IRA accounts and minimize the tax burden to beneficiaries.

  • Name an Eligible Designated Beneficiary as the Beneficiary of the IRA

While the SECURE Act eliminates the “stretch” for most beneficiaries, there are five categories of beneficiaries who may still “stretch” out distributions over their lifetime:

1. Surviving Spouses;

2. Minor children of the account owner until the minors reach the age of majority (the age of adulthood as declared by state law;2

3. Disabled beneficiaries;3

4. Chronically ill beneficiaries;4and

5. Beneficiaries not more than 10 years younger than the plan participant (such as siblings or cohabitants).

  • Name Two Primary Beneficiaries of the IRA

If a surviving spouse has sufficient resources to live without the full IRA, an effective strategy to save taxes may be to divide the IRA and name both the surviving spouse and an adult child as the primary beneficiaries. When the spouse inherits his or her portion of the IRA, the spouse can treat it as his or her own and take distributions based on his or her life expectancy. The adult child will also start his or her 10-year distribution period on his or her portion of the IRA. When the spouse passes away and the child receives the remainder of the spouse’s portion of the IRA, the child will have a new 10-year period to use the remainder of the IRA.

  • Focus on Roth Conversions

IRA owners still have the ability to convert a tax-deferred or traditional IRA into an IRA that will grow and be distributed tax-free (a Roth IRA). Income tax is paid on the market value of the amount converted from a traditional IRA to a Roth IRA in the year in which it is converted. For example, if $25,000 is converted from a traditional IRA to a Roth IRA, $25,000 will be added to the taxpayer’s income in the year of the conversion and will increase the taxpayer’s income tax liability. However, once the income taxes are paid, under current law, future withdrawals from the Roth IRA are not subject to additional income tax.

An attractive option to increase the amount passing to the beneficiaries of an IRA would be to convert a traditional IRA to a Roth IRA over time and for the account owner of the IRA to pay the associated taxes from funds outside the IRA account. Beneficiaries inheriting the new Roth IRA would still have to withdraw all funds from the account over a 10-year period but will do so income-tax-free.

For those individuals looking to reduce the size of their estate for estate tax purposes, paying the income taxes from funds outside of the IRA account that would eventually be paid by their heirs can be viewed as an additional gift not subject to gift or estate tax.

  • Purchase Life Insurance

For those individuals whose age and circumstances allow for the purchase of life insurance with affordable premiums, the purchase of life insurance to provide an additional source of liquidity at the participant’s death may be a good option. Life insurance proceeds are income-tax-free and may provide additional funds to beneficiaries to help counter the higher income taxes associated with the SECURE Act’s new distribution rules. In estates large enough to be subject to estate taxes, the life insurance can be purchased in a life insurance trust so that the death benefit can also be estate-tax-free.

  • Consider Charitable Planning Options

Many of the charitable planning opportunities with retirement accounts have not changed due to the passing of the SECURE Act.

1. Name Charitable Beneficiaries

Charities can be named directly as the beneficiary of a retirement account and no income tax will be paid by the tax-exempt charity on traditional retirement account distributions. Using retirement accounts to fund charitable bequests may allow individual beneficiaries to receive additional amounts of assets that are eligible for a step-up in basis and not subject to income tax upon receipt.

Donor-advised funds (DAFs) can also be named as the beneficiary of a retirement account. The individuals who would otherwise have been the beneficiaries of the IRA can be named as the advisors of the DAF, providing them with a source of funds for philanthropy.

2. Use Charitable Remainder Trusts

For those individuals charitably inclined, another option to consider is the use of a charitable remainder trust (CRT) as the beneficiary of the IRA. A CRT is an irrevocable trust that generates an income stream for another person for a term of years or the beneficiary’s lifetime and leaves the remaining balance to a designated charity.

The annual annuity payment to the individual beneficiary must be set at an annual percentage of at least 5% and it cannot be more than 50% of the fair market value of the assets of the trust. The remaining value, which is ultimately intended to go to charity, must be computed as at least 10% of the fair market value of the assets initially contributed to the CRT.

Let’s say Charlie has an IRA worth $1 million dollars and an adult child named Amanda. Charlie names a CRT for the benefit of Amanda with a 5% annual payout as the beneficiary of his IRA. When Charlie dies, the IRA will be distributed to the CRT and the CRT will distribute each year to Amanda 5% of the value of the CRT (computed on a fixed date each year) for the rest of her life.

When Amanda dies, the remainder of the trust will go to the charity or charities designated by Charlie when he created the CRT. While the value of the IRA will be included in Charlie’s gross estate for estate tax purposes, his estate will receive a charitable deduction for the computed value of the remainder interest passing to charity from the CRT. The amount of the deduction will depend on current interest rates and Amanda’s age when Charlie dies.

There will be no income tax due when the IRA is distributed to the CRT. The CRT does not pay taxes on the income and capital gains it earns. Amanda will owe taxes on distributions to her from the CRT and the character of the income (ordinary, capital gains, tax exempt, or return of principal) depends on the type of income earned in the CRT.

If Amanda was named directly as the beneficiary of the IRA, the IRA would have to be distributed to her within the 10-year period. Naming the CRT as the beneficiary provides an annual lifetime income stream to Amanda and helps Charlie’s charities.

Next Steps

  • Review Your IRA Beneficiary Designations

Review your estate plan and beneficiary designations in light of the SECURE Act to determine whether your plan and beneficiary designations align with your goals.

  • Consider Your Family’s Circumstances

Each family’s dynamics and needs are different. It may be important to name a trust for a child as the beneficiary of the IRA. The rules regarding trusts and distribution payout periods are complex and should be worked through with your tax, estate, and financial advisors.

If you are interested in learning more about the SECURE Act and what it means for your beneficiaries, please contact your B|O|S wealth management team to review your situation.

Footnotes

1 The SECURE Act also applies to other types of employer-sponsored plans but this article focuses on IRA accounts.

2 The age of majority varies by state (e.g., in California the age of adulthood is 18). Subject to future guidance from the Internal Revenue Service, a child may be treated as not having reached majority if he or she has not completed a “specified course of education” and is under the age of 26.

3 A designated beneficiary is “disabled” under Section 72(m)(7) of the Internal Revenue Code if he or she is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long continued and indefinite duration and is determined as of the date of the account owner’s death.

4 A designated beneficiary is “chronically ill” as defined by Section 7702B(c)(2) of the Internal Revenue Code and is determined as of the date of the account owner’s death.

Filed under: Financial Planning

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