Planning Opportunities After the Secure Act

We have had a couple of months now to digest the implications of the SECURE Act and its end to the stretch distribution rule that benefited most individuals who inherit an IRA or 401(k) retirement account on the owner’s death. Rather than permit an individual designated beneficiary to take distributions from the inherited retirement account over the beneficiary’s life expectancy, the SECURE Act’s new distribution rule requires many individual designated beneficiaries to withdraw the retirement funds over a period of ten years from the retirement account owner’s death. The obvious implication of this change in distribution rules is that rather than withdraw and report taxable ordinary income over possibly multiple decades, now all that ordinary taxable income will be reported by the beneficiary over a much shorter period of time, arguably exposing that ordinary income to marginally higher income tax brackets.

The only exceptions to this 10-year distribution rule is if the individual designated beneficiary of the retirement account are: the owner’s surviving spouse; the owner’s minor children; a disabled or chronically ill individual; or an individual who is less than ten years younger than the account owner. In the case of naming a minor child as the retirement account beneficiary, once that child attains the age of majority (18 years in Michigan) that then starts the required 10-year period of withdrawal.

However, overlooked in barrage of press releases with regard to the SECURE Act’s elimination of the ‘old’ lifetime stretch distribution rule for all retirement account beneficiaries, is yet another more flexible change in the required distribution rules with respect to a beneficiary inheriting a retirement account. That change provides that the beneficiary need not take any taxable distributions from the inherited retirement account until the year of the 10th anniversary of the death of the retirement account owner. Under the prior stretch distribution rules, the beneficiary had to start taking distributions from the inherited retirement account in the year that followed the retirement account owner’s death, and each year thereafter, in slightly larger amounts. Now the beneficiary can wait until the 10th anniversary of the retirement account owner’s death before taking that single taxable distribution, which should enable the beneficiary to better time the recognition of the taxable ordinary income distributed from their inherited retirement plan account.

Some other steps now to consider if an individual owns a large retirement account include:

determine if the beneficiary is prepared for accelerated distributions: When the stretch distribution rules were applicable, many perceptive grandparents named their young grandchildren as the beneficiaries of the grandparents’ retirement accounts in the belief that their grandchildren would have multiple decades over which to take taxable distributions from their inherited retirement account. With the ‘death of the stretch’ those grandparents may want to reconsider naming their grandchildren as the beneficiaries of their retirement accounts if they now understand that the entire inherited retirement account must be emptied by the 10th anniversary of the account owner’s death. That distribution rule may mean that too much wealth may come too fast to beneficiaries who are not prepared to manage that kind of wealth.

convert traditional iras to roth iras: As noted, one of the problems posed by the SECURE Act’s 10-year distribution rule is that all the tax-deferred income will be reported in a relatively short period by the beneficiary of the inherited retirement account. If the owner of the retirement account converted a portion of their traditional IRA to a Roth IRA, that conversion would mitigate, to an extent, the higher income taxes that beneficiary may have to pay. The 10-year distribution rule now applies to inherited Roth IRAs as well as traditional IRAs, but the benefit of the Roth IRA is that the income it generates is tax-free. Consequently, if the beneficiary receives an inherited Roth IRA, they can permit that tax-free income generated by the Roth IRA to grow for a full ten years before the Roth balance must be distributed to the beneficiary, but entirely income tax-free. A partial conversion of a traditional IRA to a Roth IRA can reduce the owner’s own income tax liability incurred on the Roth conversion, and it then reduces the beneficiary’s income tax liability when the beneficiary must take distributions from the inherited traditional IRA. The tax expense incurred by the IRA owner to convert their traditional IRA to a Roth IRA is admittedly a major drawback. However, with the relatively low current federal income tax rates and the broadened spread between federal income tax brackets enables a traditional IRA to be converted over several years to a Roth IRA without pushing the IRA owner into a marginally higher federal income tax bracket when the converted amount is recognized in their taxable income.

plan for disclaimers: Many families might consider this planning opportunity. Assume that husband and wife each own traditional IRAs. They follow conventional estate planning advice- each spouse names the other as the primary beneficiary of his or her IRA, in order to permit the survivor to rollover the deceased spouse’s IRA to the survivor’s own IRA and thus delay having to take required minimum distributions until age 72. Assume further that husband and wife each name their two adult children as the contingent or secondary beneficiaries of their traditional IRAs. Upon the husband’s death, his wife becomes the sole owner of husband’s IRA. The wife then rolls her late husband’s IRA into her own IRA, in effect consolidating the two IRAs. When the wife dies their children will each inherit 50% of the balance of the wife’s consolidated IRA. The two children must then withdraw their deceased mother’s ‘consolidated’ IRA over the following 10 years, with those taxable distributions perhaps pushing the children into marginally higher federal income tax brackets due to that taxable income bunching.
Suppose, instead, that on the husband’s death his surviving spouse disclaims a large portion, e.g., $200,000 of her late husband’s traditional IRA. That means that each of the two adult children will then directly inherit $100,000 of their father’s IRA. The children will then ratably take distributions of roughly $10,000 a year over the next 10 years. That additional $10,000 a year taxable income will probably not push the children into higher marginal federal income tax brackets. On their mother’s subsequent death, the two children will inherit the balance of her ‘consolidated’ IRA. The children will then start a second 10-year IRA distribution period, beginning with their mother’s death. In short, with a timely disclaimer by the surviving spouse of some (or potentially all) of her husband’s IRA, her children might have up to 20 years in which to take distributions from their father’s traditional IRAs, spreading that taxable income over two separate 10-year distributions. The income tax benefits of a qualified disclaimer should be discussed when contingent IRA beneficiaries are identified; while there is no obligation imposed on the surviving spouse to make a disclaimer of some of the inherited IRA, substantial income taxes can be saved through the ‘doubling’ of the 10-year distribution rule.

the charitable remainder trust workaround: A long-standing estate-planning tool, the charitable remainder unitrust, or CRUT, might be an alternative to the loss of the stretch distribution rule from an inherited retirement account. Instead of naming an individual, e.g., a child, as the traditional IRA beneficiary, a CRUT is named as the IRA’s beneficiary. The CRUT is a tax-exempt entity. Accordingly, the decedent’s entire traditional IRA is distributed after his or her death to their CRUT and no income tax liability will immediately result. Thereafter, the CRUT is directed to distribute annually some of its assets to the CRUT’s individual beneficiary, e.g., the decedent’s child. The annual distribution can either in a specific amount, i.e., like an annuity, or it can be a specific fraction or percentage of the IRA amount that was initially transferred to the CRUT, e.g., 5% distributed annually. To the extent that the CRUT makes annual payments to the lifetime beneficiary, it functions much like the ‘old’ stretch distribution rules, but with a couple of important differences. First, the present value of 10% of the initial IRA amount transferred to the CRUT must be preserved ultimately for the charity that is assigned the remainder interest in the CRUT. This 10% set-aside for the charity reduces the amount that is then available to be invested and annually distributed to the individual lifetime beneficiary. Second, the amount distributed to the lifetime beneficiary is not tied to their life expectancy; rather the amount distributed to the CRUT beneficiary must be no less than 5%, nor more than 50% of the initial amount transferred to the CRUT. The CRUT can last either for the individual beneficiary’s, thus mimicking a ‘old’ stretch distribution rule over the beneficiary’s lifetime, or for maximum of 20 years, if several individuals are named as the CRUT’s lifetime beneficiary.

While the loss of the stretch distribution rule caused by the SECURE Act is admittedly a set-back, some new estate planning strategies still exist to mitigate that loss and also to exploit new opportunities created by that Act.