By now you are familiar with the term SECURE Act that was passed in 2020, and how it impacts retirement and estate planning. A large part of that is due to the new “10-year rule” which requires certain non-spouse beneficiaries to withdraw the entire balance of their inherited retirement account within 10 years of the owner’s death. In other words, the “stretch” option is no longer permitted for this segment of beneficiaries.
The elimination of the lifetime stretch can lead to a significant tax burden for your heirs. For example, if you pass away with a $3,000,000 IRA and your sole beneficiary is your child, assuming equal distributions over 10 years, that will add an additional $300,000 of taxable income on top of any other income they receive. Distributions of this size may inadvertently put your heirs in a much higher tax bracket and can have negative repercussions on other income.
Per the chart below, the middle column of beneficiaries are the ones affected by this new rule. The stretch provision is still applicable to the Eligible Beneficiary column and no changes were made to the non-designated beneficiaries.
Since the passage of the act, we have been working with our clients, their tax professionals and attorneys to determine what strategies can help mitigate some of the tax burden brought on by this new rule. In this article, we will focus on four such strategies.
- Partial Roth conversions
- Bypassing first spouse’s death to create two separate 10-year distribution windows
- Life insurance
- Charitable Remainder Trusts to replicate the stretch provision
STRATEGY #1: Roth Conversions
Converting some of your pretax IRA into a Roth IRA will create a tax burden in the year the conversion takes place. However, once converted, the growth in the Roth IRA is tax free. Even though the Roth IRA will need to be depleted within the 10-year time frame, none of the withdrawal will be taxable. With this strategy, you first want to determine if the tax rate paid on the conversion is less than what the beneficiary would pay in taxes on the distributions later. Because the beneficiaries must withdraw the entire account by the end of 10 years, it increases the chances that their tax rates will be higher.
Let us illustrate an example:
Dale and Kathleen are retired and in the 24% tax bracket. Their son, Evan, is the sole beneficiary of Dale’s Roth IRA, which they plan to use as their primary legacy planning tool. Dale decides to convert $100,000 from his IRA to his Roth IRA each year for the next 5 years, paying the tax in their 24% bracket. When Evan inherits the Roth IRA, he is in the 35% tax bracket. By Dale assuming the tax burden of the converted amount years ago, Evan can now take out the balance, which has grown substantially tax free. If Evan were to inherit a Traditional IRA, any distributions would be taxed in his higher income bracket.
STRATEGY #2: Creating Two Separate 10-Year Stretch Windows
This strategy requires the first spouse upon death to leave their IRA to their children rather than their spouse. This starts the first 10-year clock. When the second spouse passes, the children can spread the 2nd IRA over another 10-year period. Otherwise, if spouses leave their IRAs to one other, which will eventually pass to their children, the combined, and likely larger pot of money, will need to be distributed over one 10-year period causing a larger tax burden each year to the beneficiaries. Certainly, if the spouses pass away close together, this strategy will not have the same benefit as if it were spread apart, but it is an easy way to potentially take advantage of a longer stretch period.
STRATEGY #3: Use of Life Insurance
Retirement plans tend to be one of the largest assets in one’s estate. We see many clients and prospects who have saved so well in their retirement plans and have concluded they will never spend this money in their lifetime. Instead, they want to pass this asset along to their children and grandchildren. Since the account would need to be depleted in 10 years, it is more difficult for the money to last and eventually be passed to their grandchildren. Permanent life insurance can provide that ability to “stretch” assets to the next generation. Life insurance provides a guaranteed, income tax free amount at one’s death. One strategy being utilized is to take a taxable distribution from your retirement plan on a yearly basis to pay the insurance premiums for a permanent life insurance policy.
Let us illustrate an example:
Joe passes away with a $1,000,000 IRA that will be subject to federal and state income taxes totaling 40% or $400,000 of the IRA, netting the children $600,000. Joe can purchase life insurance by taking taxable distributions out yearly from his IRA to pay the premiums. The beneficiaries of the life insurance would be able to use the income tax free insurance proceeds to pay the taxes upon death and still net the same amount of the IRA. Working with your CPA to determine what that tax burden would be is important. What needs to be evaluated is the trade-off for paying taxes now versus providing a legacy to your beneficiaries that would be income tax free.
STRATEGY #4: Charitable Remainer Trust as the Beneficiary of an IRA
A Charitable Remainder Trust (CRT) can produce similar benefits to a stretch IRA. A CRT is an irrevocable trust where a charity is the ultimate beneficiary, not your heirs. Because the charity is the beneficiary, there are no income or estate taxes on the amount left to the trust. The assets left to the trust also continue to grow tax deferred while in the CRT. Your heirs are not the final beneficiary; instead, they receive an income stream between 5% and 50% of the account value for up to 20 years. Your heirs will pay taxes on the amount distributed from the CRT yearly. This strategy requires the help of your CPA and attorney to determine if the beneficiaries are better off being a lifetime beneficiary of the CRT’s income stream or by being an outright beneficiary of the retirement assets.
In planning scenarios in which life insurance is being used to supplement or replace an inheritance, it is prudent to consider if that insurance should be purchased outside of your estate. This strategy is referred to as an Irrevocable Life Insurance Trust. This trust owns a life insurance policy outside of the IRA owner’s estate where premiums are paid for by the IRA owner. Upon the owner’s death, the life insurance passes estate tax and income tax free to replace the amount that will eventually go to the charity versus outright to the children.
The SECURE Act turned a lot of planning techniques that were used for years on their heads when it went into effect in 2020. With any impactful legacy planning change, there are a variety of strategies we can present for you to consider in leaving assets to those you care about. Alongside your accountant and attorney, we can help guide you towards the strategy(s) that would be most beneficial to you and your family for generations.