To say it’s going to take some time for the dust to settle around the SECURE Act of 2019, and for individual savers to determine its full impact on their retirement plans, may be the understatement of the year.
You may have read or heard reports about the new law (which was signed by President Trump in December and became effective Jan. 1), but no one completely understands the whole thing just yet — including the government. It’s like buying a car in its first model year: They haven’t really figured out all the bugs.
What we do know is that the Setting Every Community Up for Retirement Enhancement Act giveth to savers, with provisions that offer extra time to grow their IRAs. But it also taketh away. The SECURE Act will eliminate the opportunity for most IRA inheritors to spread out account withdrawals based on their life expectancy — a strategy known as a “stretch IRA.” Instead, if the owner of an IRA, 401(k) or similar tax-deferred retirement plan leaves it to a beneficiary other than his or her spouse, that inheritor likely will have only 10 years to distribute all the money in the account.
The change doesn’t affect beneficiaries who are disabled or have a chronic illness, minor children or individuals who are within 10 years of the age of the deceased. It also doesn’t apply to those who inherited an IRA prior to 2020. But it could have serious tax consequences for adult children who inherit during their highest earning years, especially if they’re doing well financially.
Meet Joe and Deb and Their $1 Million IRA
Here’s an example:
Let’s say you have a husband and wife, Joe and Deb, and each has $500,000 in an IRA. When Joe dies in 2022, Deb inherits his IRA – which means she now has $1 million in IRA assets. By the time Deb dies, 10 years later at age 80, she’s grown those assets to $1.5 million. And her only beneficiary is her 50-year-old daughter, Lisa.
Sounds good for Lisa, an executive, and her husband, Jim, a doctor. Except they already have a joint income of $400,000 – and a big enough tax bill, thank you very much.
Under the previous rules, their required minimum distribution (RMD) from the inherited IRA would have been $45,000 the following year, and they would be able to stretch those RMDS over their life expectancy. But with the SECURE Act in place, Lisa and Jim have only 10 years to empty the account. They can do that however they want, all at once or over time, but let’s suppose they amortize it over 10 years. Instead of $45,000, the annual distribution would be more than $150,000. On top of their already high income, this extra money will push them into the highest tax bracket. And instead of leaving a loving legacy for their daughter, Joe and Deb will have passed down a tax time bomb.
3 Strategies People Like Joe and Deb Might Consider
What can you do to make sure your inherited IRA doesn’t blow up on your beneficiaries? Here are a few options that could help diffuse the situation:
1. Convert the money to a Roth IRA.
Why put off until tomorrow what you can pay today? If you think tax rates will go up in the future (and most experts do), or if you expect your beneficiaries will inherit your money during their highest earning years, pushing them into a higher tax bracket, you may want to move your savings to a Roth account and settle the tax bill now. The timing is definitely right for those over 59½ to consider a Roth conversion. The SECURE Act has bumped the age for taking RMDs to 72, which gives savers more time to convert their funds, and thanks to the Tax Cuts and Jobs Act, tax rates should remain low through the end of 2025.
2. Withdraw the money from your IRA, pay the taxes and put what remains toward a life insurance policy.
This strategy is similar to a Roth conversion, but instead of moving the funds to a different retirement account, the money left over after the taxes are paid is used to pay the premiums on a life insurance policy that your loved one will inherit tax-free. Of course, you have to consider the tax costs vs. the insurance costs with this plan, but it makes sense to run the numbers – especially if you’re a married couple who can get a good underwriting result. Let’s face it, you couldn’t be doing a bigger favor for your child than to leave behind a big tax-free check. And you’re keeping some flexibility for yourself. Since the balance of the IRA stays in the account and continues to grow tax-deferred, you still can access that money if you need it. Any funds that remain in the IRA after your death will be inherited under the new SECURE Act rules, but because the balance will have been reduced to fund the life insurance policy, the taxes should be much less.
3. Work with your adviser and an attorney to do some trust planning.
You may be able to replicate a stretch IRA by naming your child (or grandchild) as the income beneficiary of a charitable remainder trust (CRT), which would distribute a percentage of its assets to that person for a designated period (typically longer than 10 years). When that time ends, the balance of the assets would go to charity. You’ll need to work with a licensed attorney to get into the specifics of this type of plan.
The Bottom Line
The moral of Joe and Deb’s story is that reviewing your estate plan – and your IRA’s role in that plan – is more important than ever. Yes, the government has taken away the stretch IRA strategy, but an experienced adviser who specializes in retirement should be able to help you find a good alternative. Don’t let the complexities of the SECURE Act keep you from making a move.
Whether you hope to pass down a sizable IRA or expect to inherit one, take the time now to educate yourself about what you should do next.
Kim Franke-Folstad contributed to this article.
Richard W. Paul is the president of Richard W. Paul & Associates, LLC, and the author of "The Baby Boomers' Retirement Survival Guide: How to Navigate Through the Turbulent Times Ahead." He holds life and health insurance licenses in Michigan and Florida and is a Certified Financial Planner, Registered Financial Consultant, Investment Adviser Representative and insurance professional.
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