Take-Away: On the first anniversary of the SECURE Act, the changes that it brought to retirement account distributions has resulting in some changes to how advice is given to individuals with large retirement account balances.

Background: The SECURE Act eliminated stretch IRA distributions for most nonspousal beneficiaries, replacing lifetime IRA distributions from an inherited IRA with a 10-year distribution rule. That change has created new, and more challenging, decisions to be made by the beneficiaries of an inherited IRA. For example, does the beneficiary take level distributions from the inherited IRA over the ten years that follow the death of the account owner, does the beneficiary take a lump sum distribution ‘up front’ and invest the after-tax IRA assets, or does the beneficiary wait until the last day of the 10th  (more like close to 11th year) after the account owner’s death and take a lump sum distribution at that time? The implications of the new decision created by the SECURE Act will mean, among many other considerations:

More Financial Analysis With Regard to Distributions: There will be a lot more attention given to running projections of the best case after-tax-scenarios that will be required by the beneficiaries of inherited IRAs. CPAs, trust officers and attorneys will be required to obtain and upstate software programs to be able to project the best after-tax case for the beneficiary who inherits the IRA;

More Familiarity with Trust Accounting Principles: If the IRA is made payable to a see-through trust, then trust officers will have to become far more familiar with the distinction between trust accounting income (not necessarily all of the IRA distributed to the trust) and federal taxable income (which most likely will be all of the IRA distribution.) Accumulated trust income that is not distributed to the trust beneficiary will be taxed to the trust (at least in Michigan) close to 40% of each IRA dollar.

A New Role for Life Insurance: The role of life insurance may take on more importance. With the acceleration of taxable income into a much shorter period of time with the 10-year distribution rule (contrasted with taxable distributions over the beneficiary’s life expectancy) that bunching of taxable income into a shorter period of time will expose that taxable income distributed from the IRA to marginally higher income tax brackets. The income tax-free nature of life insurance might provide the needed liquidity to pay those higher income taxes when distributions are taken from the inherited IRA. It has even been suggested (called life insurance relocation) that IRA owners over the age of 59 ½ (who are not subject to the 10% early distribution penalty) might start taking distributions from their IRA prior to age 72 years, and use those after-tax dollars to purchase life insurance on their lives. The IRA balance at the time of the owner’s death will be less, meaning less taxable income the IRA beneficiary will have to deal with. In addition, the death benefit paid when the IRA owner dies will be income tax-free and not subject to any 10-year payout rule, and if the insurance policy is held in an ILIT, the death benefit will be free from federal estate taxation. Thus, the tax-free life insurance death benefit can be used to pay the additional income taxes the IRA beneficiary will have to pay due to the SECURE Act’s 10-year distribution rule.

A New Role for Charitable Remainder Trusts: A charitable remainder unitrust (CRUT) has surfaced as a surrogate for the former stretch IRA, if the IRA owner has some charitable motives. Rather than expose the IRA assets to a mandatory 10-year distribution, the IRA is made payable to a CRUT. The CRUT pays its beneficiary (who is otherwise subject to the SECURE Act’s 10-year payout rule) over either 20 years or the beneficiary’s lifetime. In short, the CRUT comes close to replicating the former stretch distribution rule with its payouts over the beneficiary’s lifetime, at the cost of assuring the charitable beneficiary will receive at the end at least 10% of the CRUT’s initial asset value. Unfortunately due to today’s very low interest rate environment [IRC 7520], the beneficiary of the CRUT must be at least age 27 if the CRUT is to make distributions over the beneficiary’s lifetime

A Greater Emphasis on Roth IRA Conversions: Converting a traditional IRA to a Roth IRA will take on greater importance. The pros and cons of a Roth IRA conversion will require  mathematical comparisons attributed to the possibility of income tax rate arbitrage: Specifically, will the IRA owner be able to convert traditional IRA dollars to a Roth IRA at lower income tax rates than what future beneficiaries of inherited traditional IRAs will likely pay? The decision to convert a traditional IRA to a Roth IRA will entail many other considerations that include: (i) will the IRA owner (or spouse) need the IRA’s income in future years?; (ii) does the traditional IRA owner have access to other funds to pay the Roth IRS’s conversion income taxes?; (iii) will the Roth IRA owner’s spouse be able to contend with a 5-year gap, post-Roth IRA conversion, after the IRA owner’s death? (iv) How does the sunset of the current income tax rates in 2026 factor into a Roth IRA conversion analyses today? A Roth IRA has much more flexibility in implementing the owner’s estate planning directions than a traditional IRA, but the costs of conversion stand in the way of that flexibility.

Other SECURE Act Distribution Changes: A few other retirement plan contribution and distribution changes that resulted from the SECURE Act include:

  • Required Beginning Date: The required beginning date (RBD) at which the owner must begin to take required minimum distributions (RMDs) from their IRA is age 72 (up from 70 ½.) Recall that the an RMD is not eligible to be converted to a Roth IRA; only the excess above the RMD amount may be converted to a Roth IRA.
  • Qualified Charitable Distributions: A qualified charitable distribution (QCD) can satisfy the IRA owner’s RMD for the year, up to $100,000, subject to a few conditions (e.g. age 70 ½; no more than $100,000; direct distribution from a traditional IRA; not to a supporting organization or donor advised fund.) The SECURE Act de-linked a QCD to RMDs, so that an IRA owner age 70 ½ can direct a QCD from his or her traditional IRA (paying no income tax on the distribution) even though he or she has no RMD obligation for the calendar year. However, a traditional IRA contribution (see immediately below) in the same year that a QCD is made, will offset, dollar-for-dollar, the income tax-free nature of the QCD.
  • Traditional IRA Contributions: The SECURE Act removed the age restriction for traditional IRA contributions made for 2020 and later years, so long as the contribution is made with earned income.

Conclusion: The SECURE Act ‘changed the playing field’ when it comes to most IRA and qualified plan distributions to nonspousal beneficiaries, and those limited beneficiaries who fall into the category of eligible designated beneficiaries. As time passes more planning strategies will come to light to ‘workaround’ the SECURE Act’s new 10-year distribution rule. The reality is, however, that we are more likely to encounter even higher income tax rates in the years to come, which will make the mandatory 10-year distribution rule even more expensive to the beneficiaries of an inherited IRA.