The tax rule changes enacted as part of the Setting Every Community Up for Retirement Enhancement Act, or SECURE Act, will persuade financial planners and clients to take a fresh look at IRAs in estate plans.
Of particular concern are the rules regarding so-called stretch IRAs, which were changed to force inherited IRAs to be completely depleted 10 years after the death of the account owner. While these rules are not applicable if the beneficiary is a surviving
spouse, if the IRA passes to the next generation (or any other non-spouse beneficiary), the income tax embedded in the inherited IRA will have to be paid no later than 10 years following the account owner’s death.
Some (and perhaps all) of the negative aspects of losing the stretch IRA can be mitigated, however, through strategic tax planning. Every client’s personal situation is unique, and many of the changes made affect the overall after-tax consequences to beneficiaries significantly. Consulting an attorney or accountant is encouraged in order to fully evaluate how the rules apply to particular situations.
Loss of Stretch IRA
The SECURE Act basically eliminated the stretch IRA for most recipients. There are a few classes of beneficiaries that are exempt, but for most IRA inheritors the inherited IRA must be fully taxed within 10 years. Interestingly, RMDs which were previously
mandatory for inherited IRAs are eliminated. A recipient of an IRA under the new rules can leave the money in the account for 10 years without taking what would have been RMDs under the old rules. However, in that final year the entire account would
be subjected to income tax at the beneficiaries’ marginal rate, which could be a bit of a tax calamity.
For example, if a beneficiary was a successful professional, the more rapid distributions required by the SECURE Act may either move the recipient into a higher marginal bracket, or affect his / her own planning for college-age grandkids, etc. Also, this would mean that a greater slice is taken by the IRS as an IRA changes ownership. In fact, the increase in tax revenue caused by this change was used to fund some of the tax relief changes. For many families, the IRA accounts represent the bulk of the wealth to be inherited. So, client situations should be carefully reviewed to determine if their estate plans for their IRAs need to be tweaked or adjusted.
Of course, an IRA inheritor might just want to deplete the account immediately, absorbing any and all tax consequences simply for the immediately liquidity that it offers. IRA account owners can tailor an arrangement more to their liking if it is the
best fit for their circumstances. Some of the strategies available which offer significant tax savings come with a substantial loss of flexibility for the beneficiary. And, some of the decisions that have to be made are irrevocable, or least become
so when the account owner dies.
Since the tax rule changed was a pretty specific technical rule, alternatives that were previously available continue to be allowed. While these techniques may not have been as appealing to IRA owners before, the new rules might suggest taking a closer look.
Roth Conversion Approach
Converting a traditional IRA to a Roth IRA is not a new idea. But the tax cost associated with this strategy was perhaps too expensive relative to the cost of continued tax deferral under the old rules. The new rules affect the investment arithmetic here
and by reducing the “payout” period for the inherited IRA, the deferred tax will be due much sooner in many cases. So, it can make sense for an IRA account owner to take a fresh look at a Roth conversion or even a series of Roth conversions
designed to take advantage of current lower marginal brackets.
Substituting Life Insurance
Another approach worth considering in effect allows IRA account owners to substitute life insurance for an IRA as part of their financial legacy. Basically, the IRA account owner makes a withdrawal from the IRA account to fund a life insurance arrangement
(even in an irrevocable life insurance trust to sidestep a Federal estate tax). The net proceeds represent the premiums on the life insurance. Second to die or survivor life policies can be used to help those premium dollars fund an increased death
The changes made by the SECURE Act warrant taking a fresh look at trusts—already widely used in estate planning for a variety of purposes. The changes made by the Act make it worthwhile for some clients to consider charitable remainder unitrusts
(CRUTs). As the name suggests this technique involves making a gift to a charity, so it will be most appealing to someone who already has philanthropic inclinations. Basically, CRUTs allow a grantor to split an account into two conjoined parts—an
income interest and the charitable remainder beneficiary. The tax rules have allowed CRUTs for a long time, and there are well-established rules that control them. A CRUT can remain in existence for a period of time defined by a beneficiary life expectancy
or simply as a number of years. There are good reasons for choosing either alternative. One of the significant advantages offered by a CRUT is that it is a tax-exempt entity, although the beneficiary normally must pay tax on CRUT distributions. The
rules in this area are well-defined and allow dividends received by the CRUT to be distributed to the income beneficiary who would pay tax on income received at the preferential rate given to dividends.
The recent changes made by the SECURE Act require careful consideration on the part of financial professionals to develop techniques to mitigate the loss of the tax benefits of the stretch IRA.
Some of the solutions ultimately developed may involve creative applications of previously little-used approaches. For example, some thought leaders are actively exploring whether additional deferral (and tax benefits) might be available by leaving an IRA to a trust that would allow the account to accumulate, taking full advantage of the permitted 10-year deferral, and then distribute to a CRUT to take advantage of the tax benefits offered by that approach.
Such ideas—when more fully developed—may come with tax uncertainty and may only be suitable for a few more intrepid families. For most, a more conventional approach may be the best, although it may need to be more tailored than a “cookie cutter” solution. The changes which the SECURE Act has presented should be considered by all IRA owners to determine whether existing plans need to be changed.
Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.