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PLANNING IMPLICATIONS FOR INDIVIDUAL RETIREMENT ACCOUNTS AS A RESULT OF THE SECURE ACT

February 12, 2020
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We introduced the SECURE Act in a previous blog post at a higher level here, now we’re going to getting into the nitty-gritty and discuss how this *might* impact you from a planning standpoint. To review, two of the major changes to IRAs included delaying Required Minimum Distributions (RMDs) until age 72 (for those that haven’t already started taking RMDs) and the requirement that, with very few exceptions beyond a spousal beneficiary, all money in a beneficiary IRA is distributed within 10 years of being inherited. (Besides spousal beneficiaries, minor children would be exempt from the rules until the age of majority, as would disabled beneficiaries, individuals not more than 10 years younger than decedent, and those who are chronically ill – which is specifically defined by law.)

It’s possible that the impact this will have on your beneficiaries is minimal, but in a multitude of circumstances, the consequences can be severe. We’re going to address as many as we can without dragging this out, but understand that this list is not exhaustive and, once the rule has been in place for a while, more planning opportunities are likely to be discovered – talk to your advisor about your situation, because your desire for passing on the money is the primary planning input.

In this post, we’re going to discuss the first of two of the bigger problems that this law could potentially create and how we may be able to alleviate that issue. The issue is much higher annual distributions resulting in beneficiaries being bumped into high tax brackets. The second issue, which we’ll look at in the next post, is IRAs with trusts named as beneficiaries. (Estates with both human and charitable beneficiaries also deserve some discussion). All of these situations have the potential to radically change the net amount beneficiaries receive from inherited IRAs.

Regarding the issue of higher annual distributions, let’s start with an example. Say a beneficiary, age 60, inherited an IRA from a parent in 2019. That IRA, hypothetically worth $500,000, would require a beneficiary that age to distribute 3.97% in the first year, the equivalent of $19,850 (this number would be less if the beneficiary were younger and more if they were older as it is based on the single life expectancy table). Under the new law, that same beneficiary no longer has to take out anything in the first year, but they absolutely have to distribute the entire account by the 10th year. Attempting to distribute the account in roughly equal installments likely means taking out somewhere between 10-15% of initial balance (because you should account for growth, as well), annually (so $50,000-75,000 in the first year). If that same beneficiary was married, with a taxable income around $60,000 annually, the first scenario allows them to take all their income, including the beneficiary distribution, in the 12% federal bracket. In the second scenario, that same person would see as much as $55,000 taxed at 22% at a federal level, nearly double the tax consequences. Now paying 22% in federal taxes is hardly a disaster, but careful planning – with the involvement of the entire family – can address this issue partially or entirely.

What are some things parents could do to lessen this burden? Parents, assuming they plan on passing on assets to their children and have enough for themselves, could convert some IRA assets to Roth IRAs during their lifetime – effectively locking in what could be their own lower tax bracket and making it so a 10 year window for distributions has less impact on a beneficiary’s tax situation. Parents with excess funds, such that if the first spouse were to pass, they could live comfortably on their own fixed income and assets (rather than the entire household’s assets), could change beneficiary designations so that their primary beneficiary was their children rather than their surviving spouse. Assuming there was any sort of time gap between the deaths of spouses, this would allow the assets to be distributed in two ten-year windows, rather than one, potentially decreasing the tax burden in some years. (So a husband and wife, each with $500,000 IRAs, pass the first-to-die’s accounts to the child(ren) rather to the surviving spouse, allowing for the potential of inheriting $500,000 twice, rather than $1 million all at once, with the obligation to distribute that money in a 10-year window.)

The point of this is not to allow the beneficiary’s tax consequences to be the tail that wags the dog, but to realize that if you have enough for yourself and your goal is to get that money to the next generation as efficiently as possible, planning can save tens or even hundreds of thousands of dollars in taxes.

On the other hand, what planning opportunities exist for beneficiaries if they find themselves in this position? It really comes down to understanding what life stage you’re in – both in relation to retirement and in relation to your earnings potential – and making your distributions match that stage.

For example, if you’re young, married, and a relatively low earner that is likely to see your household earnings go up over the next decade, it can make sense to take larger distributions in the beginning so that they fall in lower tax brackets. You can also supplement your monthly earnings with these distributions, while simultaneously contributing to your own tax shelters if you’re eligible – deductible IRAs, HSAs (read about these here), and your workplace retirement plan. For a young couple that is eligible for all three, you could potentially take $58,100 in distributions and effectively pay no income taxes by contributing the maximum amounts to a family HSA ($7,100), two deductible IRAs ($12,000), and two max employee deferrals in 401(k)s ($19,500x2=$39,000). You’d have to discuss with your advisor whether you’re eligible for any of those types of deductions, but the opportunity set is large.

If you’re closer to retirement age – say 60 years old and planning to retire at 65 – you could take no distributions in the first 5 years (while presumably still at a higher earnings level) and then distribute the entire account over the 5-year period from 66-70. A married couple in 2020 can have over $105,000 in Gross income and still not be taxed above 12% at the federal level. This might have other positive effects, such as allowing your spouse and you to delay taking Social Security or other income options that increase over time.

For those that inherit money much later in life – say past their own RMD starting date – this again illustrates the potential positive impact of converting 401(k) and Traditional IRA assets to Roth accounts during low earnings years to prevent severe tax issues in the future (which, post-age 65 could include not just higher tax brackets, but IRMAA surcharges that apply to high income earners that are enrolled in Medicare and it’s accompanying programs).

The above examples are just three of endless possibilities. The point is that careful planning and understanding your opportunity set can make an enormous difference when distributing inherited IRAs – doing so without much thought or planning can cost you a heck of a lot of money.

In the next post, we’ll address estates with human and charitable beneficiaries, IRAs with trusts as beneficiaries, and how to achieve similar results (as those intended by current trusts) with a different set of rules. We’ll also address the (non) impact to Qualified Charitable Distributions (QCDs) as a result of the rule change. And if that’s not fun enough for you, we’ll follow the transformation of a leaf from the day it hits the compost pile to the day it becomes organic fertilizer.

 

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.  LPL Financial does not offer tax or legal advice.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.