The SECURE Act Increases Taxes on Many Inherited IRA AccountsSubmitted by Reby Advisors | Certified Financial Planners | Danbury, CT on January 9th, 2020
By Patrick Doherty, CFP®, January 10, 2020
Baby Boomers will pass on an estimated $68 trillion to their beneficiaries over the next 25 years, the greatest wealth transfer in history. The new SECURE Act – which took effect on January 1, 2020 – will likely result in more of that wealth going to the federal government instead of the loved ones of the deceased.
In this article, I’ll explain why that is and how the new law may impact our financial planning strategies with regards to legacy planning.
The Untimely Death of the Stretch IRA
Prior to passage of the SECURE Act, the “stretch IRA” strategy had been a preferred strategy of ours to help protect wealth inside of retirement accounts from excess taxation when transferred to beneficiaries (adult children, usually) after the passing of the account holders (typically parents or guardians). Prior to 2020, beneficiaries of inherited IRA accounts could take annual distributions from those accounts according to the rules on required minimum distributions (RMD), which are based on age, life expectancy and the value of the assets inside the retirement account.
The “stretch IRA” strategy had two main benefits:
- The assets had more time to grow prior to distribution to the beneficiary; and
- Since distributions could be taken in smaller annual increments rather than a larger lump sum, the beneficiary could often avoid moving into a higher tax bracket.
As an example, a single 50 year old earning $133k per year who inherits a $1 million IRA could take a distribution of $29,240 in the first year and pay only 24% of the distribution in taxes, whereas if the same individual took the full $1,000,000 at once, the taxes owed would be closer to 35%.
Now, under the SECURE Act, inherited IRA accounts must be withdrawn down to $0 within 10 years. In the example above, the beneficiary may choose to withdraw $100,000 per year, and as a result, move from the 24% tax bracket to the 35% tax bracket.
Exceptions to Changes in Withdrawal Rules
The exceptions to the 10-year rule include IRA accounts inherited by:
- disabled persons
- chronically ill persons
- individuals not more than 10 years younger than the person who passed
- certain descendent minor children, until they reach the age of majority
Alternative Tax Minimization Strategies
Now that the stretch IRA is no longer an option for most people, what options do we have to minimize taxes owed on inherited IRA accounts? Here are a few options to consider:
- Consider converting a portion your 401(k) or IRA accounts into a Roth IRA each year. The downside of this tactic is that taxes are due at the time of conversion; remember, an IRA or 401(k) contains pre-tax money. The upside is that no taxes are owed when distributions are made from the Roth IRA, creating a tax free legacy for heirs while also keeping money readily accessible to you, if ever needed.
You'll want to be very strategic about how much you convert to a Roth account each year, managing your tax bracket and weighing the benefits of tax savings at a later date against the additional taxes owed on April 15th.
- Another option is using life insurance to create that tax free legacy. You can use the Required Minimum Distributions from retirement accounts to fund the insurance policy. The key to making this strategy work with life insurance is making the decision early enough so that it's worth it: life insurance premiums are based on age and health, so the sooner you apply for a policy, the better.
- A third option is restructuring your estate plan so that you're and leaving more non-IRA assets to heirs. This may include real property or non-retirement accounts.
As we develop new financial planning strategies around the SECURE Act and estate planning, we will definitely keep you informed. If you would live personal advice on your financial plan, please do not hesitate to contact Reby Advisors at (203) 790-4949.