If you are the owner or the recent inheritor of a large IRA, the SECURE Act is likely to have a material impact on you and/or your heirs. The SECURE Act made significant changes to the way heirs are required to withdraw funds from these accounts, which will likely produce larger tax bills for many beneficiaries. This Navigator outlines strategies for both IRA owners and beneficiaries to minimize the adverse impacts of the SECURE Act.
The SECURE Act Part 2: Inherited IRAs
In early 2020, the SECURE Act was signed into law, making broad changes intended to help both those saving for retirement and retirees. The legislation affected nearly everyone in or saving for retirement to some extent, and we published a general overview of relevant changes made by the SECURE Act that were likely to impact our clients.
In this companion piece, we take a closer look at one provision of the SECURE Act with very significant implications for owners or beneficiaries of large IRAs: the elimination of the “stretch IRA,” whereby non-spouse beneficiaries could take distributions from an inherited IRA over their own lifetimes. The SECURE Act decreases the flexibility in distributions available to beneficiaries while likely increasing the tax burden upon them.
In this Navigator, we discuss strategies for beneficiaries who have already found themselves impacted by the SECURE Act, as well as for IRA owners who are seeking a tax-efficient way to pass their assets to children or younger beneficiaries.
What Changed Under the SECURE Act
Traditional IRAs can be passed to a spouse or non-spouse beneficiary. Under the SECURE Act, there are no significant regulatory changes for surviving spouses: these beneficiaries can roll an inherited retirement account into their own IRAs and use the account as if they were the original owner, just as they could before the Act’s passage.
However, the SECURE Act made significant changes for non-spouse beneficiaries. Prior to the Act, a non-spouse beneficiary could “stretch” an IRA by taking required minimum distributions (RMDs) based on his or her own life expectancy, rather than the life of the original owner. This was generally advantageous to the beneficiary, especially if the beneficiary was significantly younger than the original account owner: he or she would take smaller RMDs over a longer period of time. Assets in an IRA grow tax-deferred and are taxed as ordinary income at distribution, so “stretching” an IRA would generally allow for greater tax deferral and more than likely greater wealth accumulation for the beneficiary.
Under the SECURE Act, an inherited IRA must now be fully distributed to the beneficiary within 10 years, except if the beneficiary is a surviving spouse, an eligible minor, a person less than 10 years younger than the original owner, or is disabled or chronically ill. The SECURE Act does not make specific requirements for how an account is distributed, just that it must be completed within 10 years.[1]
While this is certainly a significant change in the law, many IRA beneficiaries may not notice much of a difference. It may not matter much year-over-year if a smaller IRA is distributed in 10 years or 20 years. Owners of very large IRAs or owners of IRAs who had planned to pass them to young children for maximum tax deferral, however, are looking at a very changed landscape for IRA inheritance, which will require new strategies.
Beneficiaries of Large IRAs
If you are the beneficiary of a large IRA that was passed on by someone who died after December 31, 2019, you are subject to the 10-year distribution rule (with certain exceptions outlined above). While you are required to distribute the full value of the IRA in 10 years, there are no other requirements for distribution, so you could take the entirety of the value as a lump sum in any year, take equal distributions each year, or vary the amount distributed in any given year.
While there are many considerations for distribution strategies beyond pure expected return on assets, it is generally advisable to take advantage of tax deferral as long as you can, especially if you are already in the highest tax bracket. In the case of an inherited IRA, this would suggest that assets should remain in the IRA as long as possible. A dollar left in the IRA will grow tax-free until it’s distributed, while a dollar that is taken out and reinvested in a taxable account will grow at a lower, post-tax rate. In theory, distributing the entirety of the IRA in the tenth year should allow for maximum wealth creation.[2]
If you have variable annual income and/or are not typically in the highest tax bracket, you may instead be better off managing your annual distributions to optimize for the lowest tax rate in each year. In years in which your income is low, distribute more from the IRA; when income is high, distribute less. This flexible strategy should allow you to minimize your tax burden over time.
In actuality, of course, the question of when to distribute from the IRA is more complicated than these hypotheticals. You may need income from the IRA on an annual basis to cover your expenses. You may expect future tax rates to rise significantly, which would mean a distribution in year 10 would be taxed at a much higher rate than one in year 1. There are a number of considerations that will determine the optimal distribution strategy for you, which should be discussed with your portfolio manager.
Owners of Large IRAs
If you are instead the owner of a large IRA and are thinking about estate planning, there are many strategies that you can consider for minimizing the tax burden on your beneficiaries. We will offer a few examples below, but this is by no means a comprehensive list; we would encourage you to reach out to your portfolio manager to discuss your individual circumstances.
Converting Your IRA to a Roth IRA
One option for owners of large IRAs is to convert that IRA (or a portion of that IRA) into a Roth IRA. As in a traditional IRA, assets in a Roth IRA grow tax-free, but unlike with the traditional IRA, contributions to Roths are made with post-tax dollars and withdrawals are tax-free.
Converting an IRA to a Roth IRA is a taxable event like any other IRA distribution, so taxes would be due in the year in which the conversion took place. However, the conversion could be done in stages over a number of years to help you manage your tax exposure.
While this approach would likely increase your tax burden during your lifetime, the assets you would pass to your heir would allow him or her significantly more flexibility in timing distributions from the account than would passing a traditional IRA. Because assets are taxed before being contributed to a Roth, qualified distributions are tax-free. To be considered “qualified,” a distribution must occur after a five-year holding period and also be made after age 59 ½, after the Roth IRA owner’s death, or under a few other special circumstances. Unlike with the traditional IRA, there is no 10-year rule for Roth IRA distributions, so your heir would be free to withdraw (or not) as he or she saw fit.[3]
One further consideration for the Roth conversion is that this option would not be available to your heir – non-spouse beneficiaries of IRAs are unable to convert them to Roths. If a Roth is an attractive option for your heir, you would need to convert it during your lifetime.
Creating a Charitable Remainder Trust
For those who intend to include charities in their estate plan, a charitable remainder trust (CRT) offers an interesting way to mimic a stretch IRA for beneficiaries while also fulfilling charitable goals. A CRT is a split interest trust, which pays some amount to a lead beneficiary or beneficiaries over a specified term (which could be the lifetime of the beneficiary). At the end of the trust term, the remainder interest goes to the charity or charities of the donor’s choosing.
If a donor names a CRT the beneficiary of his or her IRA, the assets would then be subject to the distribution rules established for the CRT, rather than the 10-year rule for IRAs. A donor then could in theory pass IRA assets to a child via a CRT over the lifetime of that child, rather than passing them an IRA that must be distributed within 10 years. The CRT has two additional advantages for the beneficiary: there is no minimum distribution requirement except for a 5% minimum annual payout and there are no penalties on early distributions.[4]
No income tax is due when an IRA is paid to a CRT, and a CRT can be created during the donor’s life or after death. If the CRT is created during the donor’s life, he or she will receive a current income tax and gift tax charitable deduction for the present value of the remainder interest. If it’s created after death, the donor receives an estate tax charitable deduction.
A potential downside of the CRT structure is that the amount of wealth passed to the beneficiary is largely dependent on how long the beneficiary lives, as the value of the trust at the beneficiary’s death would go to the specified charities rather than the beneficiary’s own estate plans.
Beneficiary Strategies
Instead of converting your IRA or creating a trust, you could also consider non-standard IRA beneficiaries to help you manage the tax consequences of the SECURE Act:
Make a charity your IRA beneficiary. If you intend to give part of your estate to charity and do not wish to provide an income stream to a beneficiary as you would with the CRT, you can instead directly pass your IRA to the charity of your choice. The charity will not be taxed on the distributions from the IRA, maximizing the benefit of those distributions. The value of the IRA would be included as part of your gross estate, but your estate would receive a tax deduction for the charitable contribution.[5]
Increase the number of beneficiaries. You aren’t limited to naming a single beneficiary for your IRA. By naming multiple beneficiaries, you would spread the IRA income out and reduce the likelihood that the income moves your beneficiaries into a higher tax bracket.
Leave your IRA directly to a young relative rather than your spouse. Typically, the married owner of an IRA sets his or her spouse as the beneficiary on the account rather than a child or younger relative. The spouse would be able to roll the IRA into his or her own account upon the owner’s death, and then would pass that combined IRA to younger relatives.
However, if you and your spouse do not need each other’s IRAs to be financially comfortable, it may be advantageous to leave your IRAs directly to your younger beneficiary rather than to each other. If you leave an IRA to your spouse, your spouse would then pass on a larger, combined IRA to your younger beneficiary, leaving them with more to distribute over 10 years. If instead you each name the younger relative the beneficiary of your IRAs, that beneficiary would receive two accounts with two different starting dates for the 10-year rule, stretching their inheritance over some longer period of time.
There are many other options for owners of large IRAs in estate planning: life insurance, other types of trusts, and different beneficiary strategies are all potential ways to help mitigate the effects of the SECURE Act for your heirs. The right strategy for you will be highly dependent on your individual financial circumstances and those of your heirs, so we would encourage you to reach out to your portfolio manager to begin discussing the options available to you.
[1] The SECURE Act
[2] The Mathematics of SECURE – Where the Tax Law and Economics Collide, Keebler & Associates LLP
[3] Distributions from Individual Retirement Accounts, IRS
[4] Charitable Remainder Trusts, Fidelity Charitable
[5] Donating Retirement Assets, Fidelity Charitable
This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”, dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other strategy in the future, there are no assurances that any predicted results will actually occur.
