Don't Let the SECURE Act Turn Your Legacy into a Windfall for the IRS
The new law takes away the popular "stretch IRA" option for most non-spouse beneficiaries, so to save your beneficiaries potential tax liability, your estate plan may need some tweaks.
The Setting Every Community Up for Retirement Enhancement Act of 2019, better known as the SECURE Act, is full of changes — some subtle, some not so much — designed to expand retirement savings opportunities for Americans of all ages.
The legislation allows older workers to keep contributing to their IRAs as long as they have earned income. It pushes back the start date for taking required minimum distributions (RMDs) from 70½ to 72. It also should make it easier and less expensive for small-business owners to set up retirement plans for their employees.
That’s the good news.
The bad news? The new law takes most of the stretch out of the “stretch IRA,” a popular tax-saving strategy for non-spouse beneficiaries who inherited all or part of a loved one’s tax-deferred retirement plan.
Before the SECURE Act took effect on Jan. 1, 2020, a beneficiary who inherited an IRA or similar tax-advantaged retirement account could take required minimum distributions (RMDs) based on his or her life expectancy. The withdrawals could be stretched over decades, along with the income taxes owed on them. Now, most beneficiaries will be required to draw down that inherited account and pay the taxes on it within 10 years of the original owner’s death. Amounts they withdraw can vary from year to year. The account, however, must be withdrawn in its entirety over a 10-year span. Those who fail to do this will face a 50% penalty of the amount they should have withdrawn, on top of the taxes they owe.
These accelerated payments will, of course, be a boon for the IRS. The Congressional Research Service estimates the new rule will generate about $15.7 billion in taxes over the next 10 years. But it could be a big problem for beneficiaries who might be pushed into a higher tax bracket, because many inheritors could be taking those compressed withdrawals during their peak earning years.
That means a lot of parents, grandparents and other generous benefactors must reassess their estate plans — or risk leaving behind a gift that’s burdened by tax consequences.
The change doesn’t apply to certain beneficiaries, including surviving spouses, inheritors who are disabled or have a chronic illness, minor children, or those who are within 10 years of the age of the deceased. And those with inherited IRAs established before Jan. 1, 2020, are grandfathered in (to their great relief, I’m sure). But others should act as soon as possible to avoid leaving behind a can of very expensive worms for their loved ones.
What should you do if you’re worried the SECURE Act is threatening the security of your legacy plan?
1. Call your financial adviser or estate attorney
Ask to go over your estate plan and talk about what changes could be made to ensure it’s as tax-efficient as possible for your beneficiaries. It’s always a good idea to review your beneficiaries regularly, just to be sure your designations are up to date and remain consistent with your objectives. But if the SECURE Act has turned your plan into a tax time bomb for your adult children, or if your hope was to provide lifetime income for an undisciplined spender, you’ll probably want to work out a different strategy.
2. Consider the benefits of a Roth conversion
Under the SECURE Act, an adult who inherits a Roth IRA is still required to empty the account within 10 years. But unlike a traditional IRA, those distributions will be tax free. You may find it makes sense to take the money from your tax-deferred retirement account now, pay the taxes on it yourself and convert those funds to a Roth account for your children to inherit. Talk to your financial adviser about spreading out those withdrawals over the next few years in a way that also minimizes your tax bill. (You have until the end of 2025 to take advantage of lower tax rates put in place by the Tax Cuts and Jobs Act.)
3. Review any existing trusts
If you’ve designated a trust as the beneficiary of your IRA (or other defined contribution plan), you should check with your estate planning attorney to see how the SECURE Act could affect distributions. The language in certain types of trusts — including popular “see-through” or “pass-through” trusts — could make them problematic now that the SECURE Act is in place. An estate attorney can determine if your trust still can accomplish your intended goals or if you need an alternate plan.
4. Consider a charitable remainder trust
A charitable remainder trust could be a good replacement for legacy plans that have lost their pre-SECURE Act luster. As an income beneficiary of this type of irrevocable trust, your loved one would receive a percentage of the trust’s assets for a specified period of time (usually longer than a decade). Then, when that time is up, the remainder of the trust’s assets would go to a designated charity. Again, your financial adviser and an estate attorney can go over the details of this plan and help you determine if it’s appropriate for your situation.
Don’t let your well-intentioned gift become a worry for your beneficiaries and a windfall for the IRS. Take steps now to minimize the tax consequences in your legacy plan. Your loved ones will thank you.
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Kim Franke-Folstad contributed to this article.