We are now a year out from the initial passage of the SECURE Act, which was followed by some further amendments under the SECURE Act 2.0 in late 2020. Your clients may have heard conflicting advice – they must change their IRA beneficiaries, spend down their IRA as soon as possible, dismantle their trust, or immediately convert their traditional IRA to a Roth IRA. Or worse, your procrastinating clients may feel that this problem doesn’t need to be addressed right now since they have a long life ahead of them.
Below are some scenarios and planning strategies to help your clients determine the best path forward under these new rules:
My client wants to leave his IRA to his spouse, minor child or other eligible designated beneficiary (EDB). EDBs are not subject to the ten-year limit. A surviving spouse beneficiary may stretch over their remaining life expectancy and the ten-year clock for a minor child beneficiary does not begin to run until the child reaches the age of majority.
My client wants to leave her IRA to a designated beneficiary. If the client is not concerned with preserving the stretch, naming a designated beneficiary (a non-EDB) as a direct beneficiary of the IRA will suffice. The beneficiaries should understand that within ten years, the IRA will be distributed to them and any income tax will be due. For a Roth IRA, the taxes are not a concern, but this could be a significant tax liability for a traditional IRA.
My client has a traditional IRA. Should she convert to a Roth? Most clients, and some advisors, might immediately jump to converting the IRA to a Roth to eliminate the tax consequences to the beneficiary. This is a sound strategy, however, is “Rush to Roth” always the answer? It depends. The SECURE Act doesn’t change the basic tenets of conversion: it only works if the owner is in a lower income tax bracket compared to the expected bracket of the beneficiary when the IRA is distributed. In addition, the owner must have the funds to pay the income tax due at conversion. If the beneficiary is a trust, Roth conversion may make more sense due to the extremely compressed trust income brackets. In 2021, the highest 37 percent income tax bracket for trusts is reached at just $13,051 of taxable income. If the beneficiary is an individual and in a lower tax bracket than the owner, retaining a traditional IRA structure may be a better planning strategy.
My client wants to “preserve the stretch.” What trust is appropriate? If the client wants to preserve the stretching out of the IRA distributions, an accumulation trust can be used. Although the IRA must still be distributed into the trust subject to the ten-year limitation rules, the trustee can distribute the trust funds to the beneficiaries or stretch them out far beyond ten years. The tax effect is that the IRA is taxable income to the accumulation trust within the ten-year timeframe, so watch out for those compressed tax brackets for traditional IRAs. For Roth IRAs, ideally the IRA can be distributed in entirety to the trust in the tenth year, giving the IRA the maximum time to grow. Your clients should also be aware that set up and administrative costs can be a few thousand dollars per year.
What about conduit trusts? Because conduit trusts are required to pay out all distributions annually to the trust beneficiaries, if a designated beneficiary is named as the trust beneficiary, any tax is still compressed within the ten-year timeframe and there is no stretch possible beyond the ten-year mark. For this reason, conduit trusts, which were once very popular IRA beneficiaries, are now largely irrelevant for designated beneficiaries. If your client has a conduit trust with a named designated beneficiary, the process to convert the trust to an accumulation trust or one of the other appropriate planning strategies must be implemented immediately. Alternately, the beneficiary could be changed to an eligible designated beneficiary that is not subject to the ten-year limitation.
After a waiver, required minimum distributions from certain retirement accounts — including traditional IRAs and 401(k)s —return for 2021.
What are some other planning strategies? Some other strategies to minimize the tax hit have emerged as advisors parse through the nuances of the SECURE Act. Since Charitable Remainder Trusts are tax-exempt, the trust can be structured so that the IRA is distributed to the trust tax-free, a taxable income annuity is paid to the non-charitable beneficiary and the remainder is distributed to the charity. The trust is not subject to the ten-year limitation no matter who the beneficiary is, so the stretch can be preserved. And of course, the tax-free benefits of life insurance combined with a life insurance trust can mimic the pre-SECURE Act stretch and tax benefits of a Roth IRA. Under this strategy, the owner can use distributions from a traditional IRA to fund a life insurance policy. The tax savings on the death benefit will be somewhat reduced by the tax due on the policy earnings, and this should be compared to the tax-savings on the growth if the funds had been retained within the Roth IRA.
Even more complex strategies are available for high-net-worth estates and beneficiaries with disabilities or chronic illnesses, but this outline should help you have smart conversations with your client about the path ahead.
