Tax Law is Good and Bad News for IRAs: Time to Review Your Tax & Estate Plans
The new SECURE Act, effective January 1, 2020, has wide-ranging consequences for income tax and estate planning. Owners of Individual Retirement Accounts (IRA) and Defined Contribution retirement accounts, such as a 401(k), should consider these steps:
- Review your IRA beneficiaries immediately if you are gravely ill. This is critical if your named beneficiary is other than an outright disposition to your surviving spouse.
- Revisit your selection of beneficiaries for retirement accounts and understand the distribution consequences. Without a review, you could be making distributions to younger individuals much earlier than expected under your existing estate plan.
- Reevaluate your post-retirement cash flow, taking into account the delayed beginning date of age 72 for Required Minimum Distributions under the new law. Should you take earlier distributions – or not? How can an optimal distribution strategy help to manage your tax liability?
Related Content: New Tax Laws Impacting Individuals and Tax-Exempt Organizations
The most important changes to IRAs
The changes Congress adopted under the SECURE Act (Setting Every Community Up for Retirement Enhancement Act), effective January 1, 2020, have wide-ranging effects on retirement accounts. Here are key changes to IRAs:
1. The required beginning age for IRA Required Minimum Distributions (RMD) increases from 70½ to 72.
This applies to persons born after June 30, 1949. Persons born on or before June 30, 1949, fall under the pre-2020 law and must take or continue to take an RMD in 2020, and thereafter. Beneficiaries of inherited IRAs and all other persons required to receive distributions before December 31, 2019, remain in pay status under the old rules.
2. The “stretch” IRA is eliminated.
After the death of the original IRA owner or 401(k) participant, distributions to beneficiaries must be completed by the end of the tenth calendar year following the owner’s date of death. The IRA may be withdrawn in partial or complete distributions during the 10-year period, or the entire withdrawal may be postponed until the required termination date. Formerly, the stretch IRA enabled beneficiaries to continue growing assets inside the IRA tax-deferred and permitted minimum required distributions over the lifetime of the beneficiary. This was particularly effective when leaving IRAs to children and grandchildren expected to live for decades.
Eligible Designated Beneficiaries exempted from this provision are surviving spouses, minor children of the owner, chronically ill or disabled beneficiaries, and persons not more than 10 years younger than the deceased owner.
3. The maximum age for contributions to traditional IRAs is repealed.
Contributions by employed persons to IRAs and 401(k)s are no longer restricted by age. Formerly, an employed person older than 70½ could not contribute to an IRA or 401(k). Now, individuals working past age 70 may benefit by continuing to add to their retirement accounts.
When do I begin taking distributions from my IRA?
The Required Beginning Date (RBD) for Required Minimum Distributions has been pushed from age 70½ to age 72. But the RBD only defines the latest date upon which the IRA owner must begin taking annual distributions. The owner may take distributions any time after reaching age 59½ without incurring the 10% income tax penalty on early distributions.
How does the later RBD affect my spending if I was born after June 30, 1949?
Many people have multiple “pockets” of assets and income sources: wages, Social Security, pension, defined contribution or traditional pension plans, IRAs and taxable investments. You can fund your lifestyle from these pockets in different ways over the course of your lifetime. Your current asset planning, goals-based asset-sufficiency analysis and investment allocation likely assume that IRA distributions start at age 70½. These analyses typically make assumptions about the most tax-efficient pocket from which to spend, based on your age, goals and various income tax consequences. Many people consider their IRAs the last money they would spend because the assets compound tax-deferred. But an important consideration is the income tax rate payable when withdrawing assets from IRAs. With a later start date for distributions, you may have a longer period of time between your retirement date and when you start taking distributions. The optimal timing of withdrawals will be different for every individual, based on income level and circumstances. Options may include taking distributions from an IRA before the required beginning date, or doing a series of conversions of your Traditional IRA to a Roth IRA, designed to manage your income tax bracket. Consult your income tax preparer to better understand the optimal withdrawal strategy for your circumstances and estate planning. For a discussion of Roth conversions, please see Glenmede’s white paper, When to Roth.
My spouse is my beneficiary. Does this need to change?
The spousal beneficiary and roll-over rules have not changed. A spouse named as the outright beneficiary (no strings attached) may:
- Roll over the inherited IRA so it becomes her own. The new required beginning date becomes the surviving spouse’s 72nd birthday and the required minimum distribution is recalculated annually based on the surviving spouse’s life expectancy. Withdrawals prior to age 59 ½ are subject to penalty. This is the option most often used; or
- “Elect” to open an “inherited” IRA as her own, in which case the required beginning date will be the deceased spouse’s 72nd birthday. The required minimum distribution is calculated on the surviving spouse’s life expectancy, and withdrawals prior to the survivor reaching age 59 ½ are not penalized. This option is most often used if the survivor is much younger than the deceased spouse.
However, if a trust for the spouse is named as the beneficiary, there may be significant new consequences, as discussed below.
Significant tax impact on children who inherit IRAs
All persons inheriting an IRA — other than the Eligible Designated Beneficiaries noted above — must withdraw all assets from the IRA no later than the end of the tenth calendar year following the owner’s date of death. The rule applies to children and grandchildren. This may have a significant impact on the timing of distributions and the beneficiaries’ income taxes, and may also impact estate planning for your family. Even if your children inherit IRAs as minors, they must withdraw the entire IRA within 10 years of reaching the age of majority under applicable state law.
Trusts named as IRA beneficiaries
We cannot be more adamant about the need to review any trust beneficiary designations with your estate planning attorney as soon as possible. Individuals designate trusts as IRA beneficiaries for various reasons, but the most common are the desire to: 1) minimize distributions from the IRA by taking that control away from the beneficiary; 2) maximize investment return by retaining assets in the IRA as long as possible; and 3) designate the beneficiaries after the death of the first inheritor.
Estate planners regularly use two types of trusts as the IRA beneficiary — conduit and accumulation trusts. Both are “see-through” trusts, meaning that the IRS considers the age of the primary beneficiary and relationship to the IRA owner in determining the payout requirements. Formerly, required minimum distributions were computed using the age of the oldest beneficiary of the trust. If the trust benefitted grandchildren, the old provision could potentially extend the period before distributions began to as long as 60 or 80 years.
he conduit trust requires the trustee to give all IRA payments received by the trust directly to the beneficiary. But if the beneficiary is not an Eligible Designated Beneficiary — for example, not the owner’s minor child or spouse — the assets must be distributed to the trust and the trust’s beneficiary within 10 years, not over the beneficiary’s lifetime. Indeed, the trust terms might be interpreted to require the trustee to take only a lump sum payment at the end of the 10 years, preventing any earlier distribution to the child. This may not be what you intended.
If the spouse or other Eligible Designated Beneficiary is the trust beneficiary, the conduit trust can still allow the minimization of withdrawals and professional management of the assets. At the death of the surviving spouse, however, the new 10-year rule takes effect, a major change from the previous rules that may upset your estate planning.
In our experience, an accumulation trust is the type more commonly used. The trustee is not required to pass through all IRA payments and may accumulate them for partial or later distribution. Under the old law, if the spouse or other beneficiary was a possible income beneficiary of the trust, the age of the eldest was used to determine the required minimum distribution. The assets could be kept in the IRA for the longest possible period before taxable withdrawals were made, minimizing taxes in the early years. Under the new law, even if the spouse is a possible beneficiary, there is no waiver from the 10-year payout rule. The change accelerates tax payments for the trust at the highest income tax rate on all income over $12,800. Once again, this is probably not what you intended.
What tax strategies to consider?
1. Your estate plan and beneficiary designations should be reviewed by a professional to determine proposed changes. The Plan should meet your personal spending goals and your future legacy goals.
2. Look for ways to minimize taxes, such as considering earlier distributions from your IRA or a Roth conversion strategy, as discussed above.
3. If you are charitably inclined, consider using a Charitable Remainder Trust (CRT) as the beneficiary of your IRA. The CRT itself does not pay any income taxes, either when it receives an IRA distribution or generates ordinary income and taxable gains. The individual beneficiary of the CRT receives a predetermined fixed amount (annuity) or percentage distribution (unitrust amount) from the CRT each year, either for life or a period of years. The distribution is taxable to the recipient as received. The CRT achieves most of the original stretch IRA objectives: professional management, tax minimization, and periodic distributions. However, it offers no flexibility regarding the amount of the distributions to the beneficiary. As a charitable trust, the term and distribution to the beneficiary must be configured so that at least 10% of the trust principal is expected to flow to the charity when the trust terminates.
4. If you have significant assets and expect to be subject to the 40% federal estate tax, consider giving the IRA outright to charity at your death. After all, the individual beneficiary will only realize about 28 cents on the dollar after paying both income and estate taxes on the IRA. In other words, your child will only realize $280,000 of a $1 million IRA.
Lastly, if you are relatively young and have substantial retirement accounts, consider whether there is a role for term life insurance, owned by a trust for the IRA beneficiary, to cover all or part of the income tax.
This material is intended to be a review of issues or topics of possible interest to Glenmede Trust Company clients and friends and it is not personalized investment, estate planning, tax or legal advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. This material may contain Glenmede’s opinions, which may change without notice after date of publication. Information gathered from third-party sources is assumed reliable but is not guaranteed. This publication may not be used as legal or tax advice.