The Setting Every Community Up for Retirement Enhancement Act, the most significant retirement law in over a decade, came into effect in January 2021. Although the SECURE Act includes many positive reforms, such as allowing joint employer plans, it also eliminated a large pension plan. tax and savings strategy: the stretch IRA.
Using an IRA stretching strategy, a non-spouse beneficiary of an inherited IRA (such as a child) could stretch IRA distributions throughout their lifetime based on the age of the individual . The strategy allowed IRA assets to continue to grow on a tax-deferred basis. It also allowed the beneficiary to avoid a potentially massive consolidated tax payment on the account balance.
In short, the stretch IRA strategy provided beneficiaries with much more flexibility in their tax and estate planning because it allowed them to take advantage of the tax-deferred growth of IRA assets throughout their lifetime.
The SECURE law removed this flexibility. The bill’s 10-year rule requires non-spouse beneficiaries to withdraw their entire inherited IRA balance within 10 years, which is problematic for several reasons, the first of which is income tax triggered by the new rule. Data from the National Vital Statistics System states that the average life expectancy for a 65-year-old is 18.5 years. So, on average, a 65-year-old retiree will live to age 83.5, after which an IRA will pass to the individual’s beneficiaries.
Non-spouse beneficiaries are probably in their highest earning years. In 2016, the Federal Reserve Bank of New York sponsored a study to determine the age at which lifetime earnings are highest. The study showed that most earners peak at age 45, while the top 20% earners peak in their 50s. Under the 10-year rule, the tax rate that non-spouse beneficiaries would likely pay on IRA distributions is often much higher than the rate that was paid by the original owner. Under this policy change, the IRS will collect more taxes, and it will do so quickly.
The second problem concerns estate planning. Many investors fear the rapid depletion of their hard-earned dollars when distributed to their beneficiaries. Estate planning through wills and trusts, as well as the stretched IRA, allowed for spendthrift arrangements.
These provisions allow the owner of the assets to “control from the grave” the percentage their beneficiaries receive at specific times. Forcing the distribution of IRA assets within a 10-year window can limit this ability. Additionally, since the Legacy IRA is to be fully distributed in 10 years, an extended generational transition of its assets is no longer an option.
Perhaps future generations will inherit taxable assets whose base will increase – adjustment of an inherited asset to its fair market value at the date of death of the deceased, minimization of taxes on capital gains – and they will not have no tax payable upon receipt of their inheritance. But the most likely scenario under current policy is that the next generation pays much higher taxes on inherited IRAs.
So how do you mitigate the negative implications of this policy change now that it’s the law? Here are three alternative strategies to consider.
First, a traditional IRA owner may consider a Roth conversion. If the owner of the IRA is retired and living off dividends and municipal bond income, that individual may sit in a lower tax bracket than their beneficiaries. By converting a traditional IRA to a Roth IRA, the owner can pay taxes at their current, potentially lower, tax bracket and remove any tax liability from their beneficiaries. This strategy has not been used in many ways. According to Statista, of the $13.92 trillion held in IRA accounts, only $1.33 trillion is held in a Roth IRA. Now is a good time to consider such a move, however, as stock markets as defined by the S&P 500 have fallen more than 20% in 2022.
If an IRA were 100% invested in the US stock index, an investor could convert the traditional IRA to Roth and pay more than 20% less taxes. The money would remain invested in the Roth vehicle, and as the market recovered, any gains would be outside of the traditional IRA’s required minimum distribution requirements.
Second, a traditional IRA owner may want to live off their IRA assets rather than the after-tax assets. This approach can create a higher income and tax rate in retirement, since all IRA distributions are taxable. However, this would allow the owner to leave after-tax portfolios to beneficiaries. This strategy would also allow the assets to grow and the beneficiaries to benefit from a capital increase when inheriting the assets.
A third strategy for IRA owners is a donor-driven fund, which focuses on leaving a legacy rather than maximizing the tax efficiency of a generational asset transfer. A DAF is an account separately maintained by a sponsoring 501(c)(3) organization, from which distributions are made to another charitable organization. By designating a DAF as the beneficiary of an IRA, all distributions made from the account are tax-free. Distributions from the DAF can be made at the discretion of the family, which oversees the fund. This approach allows family members to choose the charitable causes they are most passionate about. There are no limits on when distributions must be made, allowing the money to grow tax-free over time.
A comprehensive, generational wealth management plan is essential to each of these strategies. Working closely with a financial advisor who knows the family’s plan and each generation’s goals will not only streamline the execution of these strategies, but also ensure that they are implemented appropriately, keeping in mind mind the complete family picture.
Although eliminating the expandable IRA is a policy mistake for many American families, there are other tax and estate planning strategies that can offset the impact. Ideally, Congress would reverse course on this rule. But until then, it’s worth considering a Roth conversion, using taxable assets in retirement, or naming a donor fund as the beneficiary of an IRA.
This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Daniel Gilham is Managing Director of Consulting Strategy at Further away. He is a former systems engineer and product manager at AOL and uses that experience to help customers with financial planning.
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