Take-Away: As the passage of the SECURE Act seems imminent, many individuals with large IRAs are starting to revisit how those IRAs are handled at the time of their deaths. Conventional wisdom of the past may no longer apply if there is a mandatory 10-year payout to inherited IRAs and other qualified retirement accounts.

Background: The SECURE Act provides modest improvements to some retirement rules, e.g. extending the required beginning date from age 70 ½ to age 72, and permitting IRA contributions by an individual after age 70, provided that the individual continues to have earned income. The trade-off for these modest improvements is the mandatory payout of inherited retirement accounts over a period of 10-years, not over the designated individual beneficiary’s life expectancy (often referred to as the stretch IRA.) Actually, the way the SECURE Act is written with its effective date, the 10-year payout rule is actually closer to 11 years, because the year the IRA owner dies is not counted as part of the 10-year distribution rule. It is estimated that the tax revenues to be generated over the following 10 years with the elimination of the stretch IRA will be $16 billion. In sun, the SECURE Act is a revenue raiser. The RMD extension of 18 months and the ability to continue to contribute to an IRA after age 70 is akin to the old phrase ‘putting lipstick on a pig.’

10-year Pay-down Rule: This mandatory rule does not require equal distributions over the 10 years. Consequently, a designated beneficiary could theoretically wait until year 10 in which to take the one, final, distribution from the inherited IRA. However, that would bunch all that taxable income into a single tax year, no doubt exposing that income to marginally higher income tax rates, and possibly exposing the beneficiary to the 3.8% Medicare surtax.

Eligible Designated Beneficiaries: Excluded from the mandatory 10-year are surviving spouses, minor children, disabled beneficiaries, and beneficiaries less than 10 years younger than the deceased IRA owner. Once minors hit age 18 (or 21, depending on the state’s age of emancipation) the beneficiary starts their 10-year payout obligation. This will be a bonanza for those 18-year olds starting college if they now ‘must’ take distributions from their inherited IRA.

  • Example: Mom dies, leaving to her daughter Sandy a $500,000 IRA. Under today’s rules, Sandy’s age 37 requires a life factor of 37 years, i.e. Sandy divides the $500,000 by 1/37th to determine her first RMD from the inherited IRA the year after Mom’s death. Thus, the first year distribution after Mom’s death under current RMD distribution rules for Sandy will be $13,513.52, or less than 3% of Mom’s IRA balance at the time of her death. Assume that the inherited IRA account grows at 4% that first year after Mom’s death. If that is the case, the inherited IRA would have actually grown by about $6,500 even after the $13,513 distribution to Sandy, [$20,000 growth of 4% on $500,000 less $13,513= $6,500.]. Under the SECURE Act, if Sandy attempts to equally spread out the distributions from Mom’s inherited IRA, that would be roughly $50,000 a year in taxable distributions to Sandy, compared to the $13,513 in the first year after Mom’s death under the current stretch IRA rules. Assume, further, that Sandy is single, but has a good job  that pays to her $140,000 a year. Under current RMD rules, the additional $13,513 added to Sandy’s $140,000 income would only push Sandy up to $153,513 in taxable income for the year, thus keeping Sandy at the 24% marginal income tax bracket. With a taxable $50,000 distribution under the SECURE Act’s 10-year payout rules, Sandy’s taxable income would be roughly $190,000, subjecting about $29,275 of the $50,000 IRA distribution to the higher 32% marginal federal tax rate, which starts for Sandy at $160,725. Obviously, the shorter IRA distribution period will cause significant increases in income taxes for Sandy.

Planning Considerations: With the elimination of the stretch IRA will come new planning considerations. Some have been touched on before, and some may entail some counter-intuitive planning.

Charitable Remainder Trust: If the IRA owner is somewhat charitably inclined, they might name a charitable remainder trust (CRT) as the designated beneficiary. The CRT will mimic, to a degree, the stretch IRA, in that the IRA assets paid to the CRT will be distributed to the CRT beneficiary over the CRT beneficiary’s lifetime, with the remainder of CRT assets passing to the charitable remainder beneficiary, e.g. a donor advised fund, on the CRT beneficiary’s death. Naming the CRT as the IRA beneficiary avoids the immediate income taxation of the IRA balance, while the distributions from the CRT to its beneficiary will be taxable at ordinary income, but perhaps only 5% of the CRT corpus will be taxed to the beneficiary each year, not 10%. A CRT might be a workable solution for a very large IRA, but for a smaller IRA, the time and cost associated with setting up and administering the CRT may not make much sense.

Roth Conversions: For this strategy to work the IRA owner must convert their traditional IRA to a Roth IRA while alive. Restated, the beneficiary of the inherited IRA cannot make the Roth conversion. With the inherited Roth IRA the beneficiary will still face the 10-year payout, but at least all of the distribution will be income tax-free to the designated beneficiary for that 10 year period, thus avoiding any income bunching into higher marginal income tax brackets. The drawback to this strategy is the drawback to all Roth IRA conversions- having sufficient ‘outside’ assets to pay the voluntarily incurred income tax on the Roth IRA conversion. Exploiting the relatively low income tax rates before 2026 might warrant more traditional IRA owners to explore a Roth conversion now in order to prevent causing more taxable income pushing their designated beneficiaries into marginally higher tax brackets later.

Spray Trusts: A multigenerational spray trust might make sense in order to manage taxable income for the trust’s beneficiaries. Instead of leaving an IRA to a grandchild, which was the classic stretch IRA planning strategy of the past, with the SECURE Act required mandatory 10-year payout, a spray trust would permit the trustee to spray the taxable income paid to the trust over a large number of beneficiaries, limiting the impact of the larger annual RMD distribution.

  • Example: Grandfather had planned to name his grandson as the beneficiary of his $1.0 million IRA. With the new 10-year payout, the grandson would report $100,000 a year as taxable income (added to the grandson’s own taxable income.) If the grandfather added his son and daughter-in-law, and another grandchild as potential income beneficiaries of a single trust, the annual distribution from the inherited IRA to the trust could be spread over 4 beneficiaries, i.e. $25,000 to each,  possibly keeping each beneficiary at a lower marginal federal income tax bracket. The drawback to using a spray trust is that it might not fit with the IRA owner’s goals and donative objectives.

Spousal Planning: Conventional wisdom is to name a surviving spouse as the designated beneficiary of an IRA, with the children named as contingent beneficiaries of the IRA. That makes sense in light of the fact that the surviving spouse is an eligible designated beneficiary who can use his/her own life expectancy to take distributions from the inherited IRA, or use a simple rollover into their own IRA. While naming a spouse as IRA beneficiary makes sense from an estate tax perspective, with larger federal estate tax exemptions and portability of the deceased spouse’s unused applicable exemption amount, which often results in no estate tax on the deceased spouse’s IRA balance, it also might lead to even larger inherited IRAs for the married couple’s children who are named as the survivor’s IRA beneficiaries. This problem is aggravated if both spouses have their own IRAs. In a sense, by naming the spouse as the primary IRA beneficiary, the two spouses’ IRAs are aggregated into a single IRA, and if the survivor only takes required minimum distributions during his/her over-life, more IRA will be subject to the mandated 10-year payout on the survivor’s death. It may make sense to completely skip the surviving spouse as the designated IRA beneficiary (or hope the survivor will disclaim some or all of the IRA on their spouse’s death.) In short, by splitting the IRA among spouse and children might result in tax savings overall.

  • Example: Ward and June, each age 85, each owns a $1.0 million IRA. Ward dies. June is named as the beneficiary of Ward’s IRA. June has a distribution period of 14.8 years given her current age. If June is Ward’s IRA beneficiary she will have an RMD of $67,567 from his IRA. When added to her own IRA’s RMD, June’s aggregate RMD for the first year after Ward’s death is $135,135. June would move from the 22% income tax bracket to the 24% income tax bracket when she reports her RMD from Ward’s IRA along with her own RMD. Admittedly, that 2% is not a big move in income tax brackets. But if June had other taxable income besides IRA distributions, e.g. maybe $80,000 from other sources like portfolio income, taking an RMD from Ward’s IRA and adding it to her own taxable income could take June from the 22% marginal income tax bracket to the 32% marginal income tax bracket. Assume the same facts, but instead Ward names June, and their two sons, Wally and Beaver, as one-third beneficiaries of Ward’s IRA. June’s one-third of Ward’s IRA will distributed over close to 15 years. Wally and Beaver will withdraw their portions of Ward’s IRA over 10 years. In effect, the taxable distributions from Ward’s IRA will be spread over three families. More importantly, if June lives another 10 years and then dies, naming Wally and Beaver as the beneficiaries of her remaining IRA balance, Wally and Beaver will start yet another 10-year payout of their late mother’s inherited IRA. In effect, Wally and Beaver will withdraw two-thirds of Ward’s IRA over a 20 year period, not a 10 year period. By splitting Ward’s IRA on Ward’s death, Wally and Beaver will be able to extend the RMDs over two separate 10-year periods, thus minimizing the income tax burden on those distributions.

Life Insurance: If a primary goal is to transfer as much wealth as possible to the next generation, then an individual IRA owner might once again take a look at establishing an irrevocable life insurance trust (ILIT.) The heavy income taxation of the IRA distributed to the beneficiary could result in about half of the gross value of the IRA account actually being received by the IRA beneficiary if the federal income tax (37%) the federal Medicare surtax (3.8%) and state income tax (4.25% or higher if the beneficiary lives on one of the coasts) is taken from the required 10-year payout. Life insurance (through the ILIT) could be used to help provide the liquidity required to pay the additional income tax on the shorter IRA distribution period. While many have thought that existing ILITs might no longer be required due to the large federal estate tax exemptions now available (at least until 2026 when the old, lower, exemption amounts return) this may be yet another reason to keep an ILIT in place to help the beneficiary pay higher income taxes on IRA distributions.

Conclusion: With the required 10-year payout caused by the SECURE Act, many existing IRA beneficiary designations to see-through trusts will no longer make much sense from a tax planning perspective. Each trust, whether conduit or accumulation, will face its own 10-year RMD rule. Some of these trusts will have to be revisited and their terms re-evaluated in light of the loss of the stretch IRA opportunity, which may have been the primary reason to name the trust as the IRA beneficiary in the first place. In addition, the conventional wisdom of naming a surviving spouse as the primary beneficiary of an IRA may not make as much sense, especially if the surviving spouse has his/her own IRA, where an aggregate of the two IRAs (the survivor’s IRA and their inherited spouse’s IRA) will be exposed to one 10-year payout, when exploiting two separate 10 year payout periods might mitigate the income tax erosion caused by higher marginal income tax rates.

My next missive is, quite candidly, a rant with regard to Congress’ stealth tax under the guise of the benign SECURE Act.