• Daniel Satz

Feeling Even More SECURE About Retirement

Key Takeaways

  • Most inherited IRAs received in 2020 or later must now be withdrawn within 10 years.

  • The lifetime “stretch” is no longer available to most beneficiaries.

  • The future tax landscape is highly uncertain, but rates most certainly will go up.

  • Consider Roth conversions, retirement plan trusts and charitable remainder trusts.

Having a long and healthy retirement has long been part of the American DNA. But as the nation’s savings rate continued to shrink before COVID, Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act in late 2019 to retirement saving easier and more accessible for many Americans. The SECURE Act raised the RMD age to age 72 from age 70-1/2, which gave good savers an extra 18 months to delay taking taxable distributions on money they didn’t need right away. The SECURE Act also opened up 401(k) plans to part-time workers and provided many new incentives for small business owners.


As with so many well-intended policies, however, the SECURE Act created new challenges for those who were already good savers and who stood to inherit nicely from their families. To help pay for lost tax revenue from raising the minimum RMD age and opening retirement plan deferrals to part-time employees, non-spousal beneficiaries must now withdraw the entire value of the IRAs they inherit within 10 years. The withdrawals can be spread over 10 years to maintain a consistent tax liability on the distributions, or the entire amount can be withdrawn in one lump sum. Before the SECURE Act was passed, beneficiaries could “stretch” out their IRAs throughout their lifetime, which minimized taxes, particularly for younger beneficiaries. Ironically, the SECURE Act created an unintended situation in which millions of children or other beneficiaries of affluent retirees will be receiving substantial windfalls that they might not be financially responsible enough to handle.

Minimizing RMD tax stress post-SECURE Act

We have clients with millions of dollars in their IRAs, but their adult children are also high earners who are already in high tax brackets. The last thing our clients want to do is give them an additional tax burden paying for the tax on an inherited IRA. What to do? As my colleague Ryan Dunn wrote recently, Roth conversions are one of the best techniques you can use to get money out of your traditional IRAs. The idea is that you are paying the tax on conversions now, which may be at a lower tax rate than what you think your children or other beneficiaries will be paying when they inherit the money. Here are three smart ways to do so:

1. Roth Conversion Converting your traditional IRA to a Roth IRA before it is passed on to your children allows you to take care of the tax responsibility of those distributions and the money continues to grow tax free and will be distributed tax free to your children. That’s not just being generous to your children--most experts expect marginal tax rates to go up significantly in the future.

2. Retirement Plan Trusts

As mentioned earlier, many high-net-worth people have worked hard to accumulate sizeable traditional IRAs, but do not think their children or other beneficiaries are financially responsible enough to handle them. It’s especially true when new RMD rules require beneficiaries to withdraw the entire account in just 10 years.

A retirement plan trust is a strategy that has been used for years to ensure that even an IRA account that passes by contract will protect heirs who may not be good at managing money. This type of trust also prevents creditors from seizing the assets if your beneficiary should file for bankruptcy. A retirement plan works in tandem with a pass-through trust. The pass-through trust can be a testamentary trust (created upon your death), or it can be an existing irrevocable trust. It is not possible to include your IRA in a trust while you're still alive, but you can name a trust as the beneficiary of your IRA. Then the trustee distributes funds to your heirs according to your wishes. The SECURE Act did not alter this strategy. Just remember that if you wish to restrict distributions to the beneficiary, the tax consequences can be quite large since distributions from the retirement plan trust that remain in the pass-through trust will be taxed at much higher rates. While income to the beneficiary can be controlled, the principal can be eroded substantially. This is another reason why you should try to convert portions IRA to your Roth IRA in lower income years.

You don’t want your beneficiaries to spend inherited recklessly. At the same time, you don’t want to overpay taxes on money that’s sitting in the trust. Our firm spends a great deal of time with our clients and their estate planners to find the right balance.

3. Charitable Remainder Trust (CRT)

If you have a substantial IRA and are charitably inclined, a charitable remainder trust may be a great solution for a) stretching distributions to beneficiaries beyond 10 years, and for b) fulfilling a desire of gifting to a charity (or charities) of your choice.

Instead of naming individuals as beneficiaries of your IRA, you can create a CRT and name the CRT as the primary beneficiary. Upon your death, the IRA is distributed to the trust completely tax-free, and continues to grow tax-free, since a CRT is a tax-exempt entity. The person named as the non-charitable income beneficiary of the trust, however, pays ordinary income tax on the distributions they receive at their individual tax rate. One caveat is that at least 5% of the value of the trust must be paid out annually to the non-charitable beneficiary. In this case, the trust can be structured so that payouts continue for 20 years or more. This allows the beneficiary to maintain their lifestyle but prevents them from getting access to too much money all at once. There are other specific rules that need to be met for this type of strategy to be valid. Consulting with your financial planner can shed light on whether this option is right for you.

Real world example

One of our clients is in his late 50s and makes a very modest income. Because most of his income must go toward paying bills, he hasn’t been able to contribute much to his own 401(k) plan. However, he inherited a sizeable IRA from his parents, who both passed away recently.

Again, the new rules on RMDs require our client to withdraw all the money from his parents’ IRA within 10 years, so he can no longer “stretch” it out. We recommended that he completely max out his 401(k) contribution for the year ($25,000) so it can grow tax deferred. Even though that $25,000 is a significant chunk of his paycheck, we can supplement that income with the distributions from the IRA.

Bottom line: our client is finally able to start saving for his own retirement in his 401(k). Even better, the first $25,000 in distributions he’s taking from the inherited IRA is being offset by his 401(k) contribution. Then, when he retires in about four years, and presumably moves to a lower tax bracket, we can beef up the distributions from his inherited IRA until the 10-year window closes. So, instead of taking the usual 10% a year for 10 years, he will be taking approximately 7% distributions from the inherited IRA while still working, and then closer to 13% a year during the next six years when he is retired.

Conclusion

No one knows exactly what the tax landscape will be in the near future and beyond. All you can do is control what we can control. Make sure your estate planning is done correctly and keep your tax liability as low as it can be within the current rules.

If you or someone close to you has concerns about your estate plan or retirement readiness, please don’t hesitate to reach out. We’re happy to help.

DAN SATZ MS, CFP® is a Wealth Manager at Novi Wealth