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January 17, 2020
Tax & Estate Perspectives
Taxes
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Important Tax Changes on Retirement Plan Accounts
In a rare display of Washington bipartisanship, Congress recently passed what is known as the SECURE Act. The new law is driven by an effort to enhance the ability of American taxpayers to save for retirement, but it also causes significant changes to the timeline for when retirement savings are taxed as income. These changes will hit the beneficiaries of inherited retirement account balances.
The growth of modern retirement plan accounts, such as 401(k) accounts, tax-deferred IRAs, and Roth IRAs (to keep it simple, all of these accounts are referred to below generically as IRAs) has been fed by favorable tax rules that encourage maximum funding by the account holder during salary-earnings years. The favorable rules have included front-end tax-deferral of IRA contributions (or in the case of Roth IRAs, back-end nontaxable distributions), and income tax-free growth of the investments while inside in the account.
In addition, and most pertinent to the current change by Congress, retirement account savers could count on the retirement funds being a source of lifetime cash flow to the surviving family and beneficiaries after the account holder’s death. This ability to have inherited IRA accounts pay out over the lives of the surviving family members led to the common terminology “stretch IRAs”. A stretch IRA was not a legal term, just a coined and marketed reference to a planning technique to achieve the potential and powerful long-term benefits of tax-deferred growth in account investments.
What Changed?
There are several changes to consider in planning with retirement accounts, but perhaps most importantly, the SECURE Act curtails the long-term benefits of IRA tax deferral, mostly eliminating the “stretch IRA” concept. With a few exceptions, a mandatory 10 year distribution period is now imposed on inherited IRAs (this change only applies after the death of the retirement account holder). In short, by December 31 of the 10
th
year following an IRA holder’s death, the inherited retirement accounts must be completely distributed to the designated beneficiaries. The distributions can occur throughout that period, or entirely in the 10
th
(or any other) year of that period. The change in the law applies to all IRAs of account holders who die after 2019.
An unfortunate impact of the 10 year distribution period, is that after years of maximizing IRA contributions and realizing investment returns inside the IRAs, these returns will now be subjected to ordinary income rates in a much shorter time period. Maximizing the use of IRAs, with the understanding that heirs could potentially have a lifetime source of supplemental cash flow on a tax-efficient basis, was a fundamental aspect to tax planning. That life expectancy payout was the tradeoff for the reality that investment gains would instead be taxed at higher ordinary income tax rates, and without regard to cost basis of the investments inside the IRA. This tradeoff has been negatively impacted by the SECURE Act.
There are other changes to consider. Required minimum distributions to the account holder will not have to commence until age 72, rather than the prior rule of age 70½. Also, taxpayers now can continue making contributions to IRAs beyond age 70½, although this change might have less appeal for some given the elimination of the stretch IRA planning and avoiding excess account buildup.
Assessing the Change
There are a variety of tax and nontax aspects to consider with the change to the 10 year distribution period for inherited IRAs. Here are some quick issues that we will be working through with clients who are impacted. Of course, there is no one-size-fits-all solution; every situation has unique factors to consider.
Regardless of the size of a person’s IRA, thought must be given to the timing of heirs receiving the required IRA distributions. Even modest IRA balances may exceed what an individual beneficiary should receive within a 10 year post-death window.
All IRAs that are designated to pay out to revocable or irrevocable trusts must be promptly reviewed. A common design of existing trusts has been as a “conduit”, meaning any trust receipt of an IRA distribution was immediately passed on to the trust beneficiary. This was done to qualify the trust for minimum distributions over a life expectancy. Now, with a 10 year limit on inherited IRAs, distributions in many cases cause a conduit trust to be ill-advised, as it will force large sums of money to be paid out to beneficiaries too young or ill-equipped to receive them.
The options to consider when designing a trust as the beneficiary of an IRA must take into account the income tax brackets of trusts. Irrevocable trusts funded after a person’s death usually pay income tax at the current rate of 37% when exceeding income of about $13,000 per year. Trusts pay much more income tax than do individuals on the same amount of income. Thus, there will be a difficult tradeoff to consider with keeping the accelerated IRA distributions in a protected trust (paying income tax at the trust level), as opposed to distributing large sums of money from the trust to individuals who should not receive them for any variety of personal factors.
Under prior law, continuing with regular IRAs might have rated more favorably than a taxable conversion to a Roth IRA, given the potential decades of tax deferral before income tax was charged on distributions. Now, with a 10 year inherited IRA limit on distributions, a Roth IRA conversion, at the cost of immediate taxation, should be reviewed based on each client’s overall tax situation. A Roth conversion should first and foremost be driven by the client’s overall tax rate now versus later. .
A workaround to consider on the 10 year distribution limit is to change the designated beneficiary to a charitable remainder trust. Such a charitable trust would be the IRA beneficiary and structured to provide annual trust distributions to named individuals, followed by a termination payment to charity at the end of the trust term. A CRT term can be up to 20 years, double the new limit on inherited IRA distributions. So, in some situations where there is charitable intent in the estate plan, this is an option to evaluate.
While this change caused by the SECURE Act might present challenges to achieving tax-advantaged IRA growth and distribution, there will be planning options for each person to consider. What needs to be remembered for the moment is that mass-marketed solutions, being floated by all varieties of commentators, will not necessarily work in any given situation.