Updated: Mar 20, 2020
Towards the very end of last year (2019), the U.S. Congress passed the SECURE* Act which among other changes, impacted how an inherited IRA and other tax-deferred accounts such as 401(k), 403(b) are required to be distributed from the inherited beneficiary accounts. I would like to give you quick perspective on this significant aspect of change - leaving retirement funds to your beneficiaries.
Death of the Stretch IRA rule
Prior to 2020, beneficiary of an inherited retirement accounts was required to take RMD (Required Minimum Distribution) based on their life-expectancy tables. This was called "Stretch IRA" rule. So if the beneficiary, typically son or daughter, would be drawing down on the account at a much lower rate (2-3%) and thus may not impact their taxes adversely. For example, RMD for an inherited IRA account of $1M would between $2,600 to $3,000 per year for a 45-50 year old prior to the SECURE Act.
However, the SECURE Act changed the time period of distribution of the beneficiary account for IRA accounts to a maximum of 10 years after death of the account-holder with a few exceptions. Since this year, $1M inheritance of a retirement asset would require $100,000 per year withdrawal during the prime time of your beneficiary. While the 10-year draw-down rule provides flexibility on when the funds can be withdrawn, the payout may have unintended consequence of higher marginal taxes, for beneficiary. A beneficiary in 22-24% tax bracket would be paying 32-35% in federal taxes. This also reduces the potential for tax-free growth of the remaining fund during the beneficiary's life-time. Oouch!
Exceptions to the 10-year rule applies to "Eligible Designated Beneficiary", namely
child under majority age (18 or 21 depending on the State) or a full-time student
chronically ill or disabled and
beneficiary who is not more than 10 years younger to the deceased
Once a beneficiary child reaches age of majority (varies by state), the 10-year distribution rule will apply. For example, a 10-year old child could withdraw say about 1.4% to 1.5% until age 18 (majority age in California) or even 26 if the child is a full-time student. Subsequently, the child must take the remaining funds within the next 10 years. This exception does not apply to grandchild.
Need to re-plan on Retirement Spending Strategy
This presents a unique planning opportunity to reduce the impact of taxes on distributions. Typically, retirees take money from taxable accounts first because of lower taxes on long-term capital gains on appreciated investments. A different strategy would be for retirees to withdraw from the tax-deferred IRA accounts first and leave the taxable account to the beneficiary. Thus the taxable investments will receive a step-up in basis to the beneficiary and they can withdraw the appreciated fund without paying any taxes.
Another scenario would be to systematically convert IRA accounts to Roth IRA during the lifetime so that the beneficiary can enjoy tax-free withdrawal from Roth IRA. Nevertheless, the beneficiary must exhaust the inherited Roth IRA account in 10 years but it provides for 10 years of tax-free growth, assuming the funds are needed immediately. For example, a $600,000 fund could easily double to $1.2M in 10 years tax-free.
How to grow Roth IRA account
Roth accounts grow tax-free and can be withdrawn tax-free after 59.5 years and there is no RMD** requirement. On the other hand, RMD from a large IRA accounts could increase the taxes in retirement and increase Medicare premiums since distributions are treated as ordinary income. One should start thinking about building up the Roth IRA account during the earning years. With the new law, "certain taxable non-tuition fellowship and stipend payments" are treated as earned income (according to IRS) and eligible for Roth IRA contribution. This is an opportunity for college students to start saving in Roth IRA.
There are many ways to save into a Roth account instead of traditional tax-deferred account. If your MAGI (Modified Adjusted Gross Income) is under a threshold (example $196,000 for Married-Filing-Jointly in 2020), a couple can contribute $6,000 (+$1,000 over age 50) each towards Roth instead of Traditional IRA, forgoing current year tax deduction. Employers also offer Roth 401(k) option in employer-sponsored retirement plan to contribute funds directly from paycheck and it has no income threshold limit. Another common technique used by high income earners is to perform "backdoor Roth conversion" every year or a more restrictive "mega backdoor conversions" within employer's 401(k) plan. Additionally, it pays to look into opportunities for Roth conversions during lower tax years, for example during a sabbatical or gaps in employment. Another planning strategy is to perform regular Roth conversions of amount that would "fill-up" the current tax-rate threshold but paying taxes now than later. Please contact a tax professional or an advisor for understanding these options.
Revisit your Estate Plan and Beneficiary Designations
With these changes, there is an immediate need to revisit the designated beneficiaries and your Estate Plan in order to save on "inter-generational" taxes. Also, naming secondary beneficiary becomes important to allow for flexibility to partially or fully pass on the accounts to a secondary beneficiary post-death if it makes sense. There are many avenues such as Trusts, Charitable Remainder Trust (CRT), Life Insurance products etc. that should be explored before leaving a substantial amount to your beneficiaries. Consult your estate planning attorney regarding these changes to your estate plan.
As you can see, SECURE Act of 2019 has far reaching implications on your estate plan and it will require careful planning. In summary, the SECURE Act definitely tilts the scale in favor of Roth IRA conversions and Roth IRA contributions if you want to do tax-efficient wealth transfer to your beneficiary.
Please reach out to me on how you can maximize leaving your legacy and not leave a burden of taxes on your beneficiaries.
*SECURE - "Setting Every Community Up for Retirement Enactment.
**RMD - Required Minimum Distribution