Signed into law on Dec. 20, 2019, the SECURE Act drastically changes the estate planning landscape and brings significant changes to the tax rules governing the inheritance of individual retirement accounts (IRAs).
The most notable change brought by the SECURE Act is the elimination of the “stretch rule” for most non-spouse beneficiaries. Previously, beneficiaries of an inherited IRA could withdraw from inherited retirement accounts over their lifetime – called stretching the distribution. The beneficiaries were required to take “required minimum distributions” (RMDs) each year in proportion to their remaining life expectancy, and the length of time over which the account must be depleted was calculated based on the beneficiary’s life expectancy.
With the stretch rule, compound interest and deferred taxation meant that even a modest inheritance would result in a significant lifetime payment for a beneficiary. For example, a ten year old beneficiary of a $100,000 IRA earning 10% annually who took RMDs would withdraw close to $14,000,000 over their lifetime.
Many estate plans took advantage of the stretch rule to provide a lifetime income stream to beneficiaries while allowing the bulk of the IRA balance to accrue compounded interest over the lifetime of the beneficiary.
The SECURE Act removes the stretch rule for most beneficiaries, requiring the entire IRA to be withdrawn within 10 years, while also removing the RMD requirements.
Certain beneficiaries are exempt from the new rule. These include:
If your estate plan includes an IRA account, and the beneficiaries of the account do not fall into one of those categories, you will likely need to review your estate plan.
Conduit trusts are special “see-through” trusts that can serve as beneficiaries for an inherited IRA. Because the trust is “see-through”, meaning the distributions from the IRA to the trust are immediately passed on to the beneficiary of the trust, the trust is legally permitted to use the life expectancy of the beneficiary. Therefore, a conduit trust allows you to create an income stream for the beneficiary over their lifetime without ceding control of the entire IRA balance to the beneficiary.
This strategy is frequently used when one has spendthrift children, or family members who often find themselves in financial hardship. With the use of the conduit trust, these family members can be provided with a steady income stream without relinquishing control of the entire account to the beneficiary.
Due to this nature, most conduit trusts include language that limits distributions to only the RMD. Because the new 10 year rule eliminates RMDs, and simply requires that the balance of the account be fully withdrawn by the end of the tenth year, such conduits trust result in the entire IRA being paid out to the beneficiary at the end of the tenth year. In addition to resulting in a potentially huge tax liability in the process, this outcome entirely subverts the purpose of a conduit trust set up to establish a lifetime income stream and prevent lump sum withdrawals.
If your estate plan includes a conduit trust, you should review your estate plan as soon as possible.
If your estate plan includes a conduit trust, or you intend to leave your retirement account to a non-spouse beneficiary, you will want to take steps to mitigate the effects of the SECURE Act on your estate. While you will need to make changes to your estate plan, the good news is there are alternative strategies you can employ to mitigate most of the impact of the SECURE Act.
The simplest strategy is to split beneficiaries as needed to defer some portion of the income being realized until a later date.
Let’s imagine, Suzy, who is 30, is set to inherit a $1,000,000 IRA account from her father. Under the old stretch rule she would have been able to make annual withdrawals of just under $20,000 per year. Under the new 10 year rule, she will be required to make withdrawals of $100,000.
Now let’s say Suzy’s mother is added as a beneficiary to the same IRA. Now, Suzy can make $50,000 per year withdrawals, while mom can roll the inherited IRA into her own IRA account.
When Suzy’s mother passes, Suzy will have a new 10 year period on the other half of the account, substantially increasing the distribution period, and decreasing the tax burden.
Irrevocable Life Insurance Trusts (ILITs) are a staple of many estate plans. They are living trusts set up specifically to own a life insurance policy, and allow you to exempt the value of your life insurance policies from your estate with some restrictions. While you may already be utilizing an ILIT as part of your estate plan, you may wish to consider making accelerated withdrawals from your IRA and using them to purchase additional or larger life insurance policies to place in an ILIT. This strategy can still enable you to leave a steady income stream for your beneficiaries without relinquishing control of the entire account at once.
If part of your estate plan was to provide a lifelong income stream for a spendthrift beneficiary without ceding control over the assets, you can still accomplish this goal using a charitable remainder trust. A charitable remainder trust is a trust set up to make a stream of payments to a designated beneficiary over their lifetime, while the remainder of the assets in the trust upon the beneficiary’s death are distributed to charity.
There is, however, a caveat to this strategy. Unlike a conduit trust, the beneficiary cannot choose to take out money more quickly.
Sometimes, due to retirement, you are the lowest tax bracket member in your family and all your beneficiaries are at their peak tax years. When that is the case, it may make the most sense for you to pay the tax bill on your retirement account by converting a portion of your IRA into a Roth IRA. The conversion will create taxable income for you, while the Roth IRA itself is tax exempt for the beneficiary. Especially if you find yourself in a high deduction year, or with a large number of charitable contributions or medical expenses, converting a portion of your IRA into a Roth IRA will offset some of the deductions, and allow you to minimize the overall tax burden on the retirement account.
If you would like to learn more about how you can adapt to the changes in the SECURE Act and keep your retirement fund out of the top tax bracket, contact us today for a no-obligation consultation. Mile High Estate Planning can help you amend your estate plan to avoid costly income tax bills to your beneficiaries and avoid losing control over your inheritance plan.