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Major Changes to Estate Planning with Retirement Accounts
With the rush of the holiday season behind us, the long march of winter provides us with the opportunity to reflect on our goals for the rest of the year. For many of you, estate planning was a goal that you had in years past. For better or worse, recent changes in the law now mean that it is an important time to revisit aspects of your estate planning.
Specifically, the Setting Every Community Up for Retirement Enhancement Act (SECURE Act), signed into law on December 20, 2019, drastically changes the rules for inherited IRAs.
Prior to the SECURE Act, if you owned an IRA (or 401(k), etc.) at your death, then your beneficiaries could take required minimum distributions (RMDs) over their own life expectancy. This was commonly referred to as a Stretch IRA, and it was permitted for individual beneficiaries, as well as trusts meeting certain requirements. Indeed, many of my clients created Conduit Trusts precisely to take advantage of this opportunity for an additional lifetime of tax-deferred growth. The results were truly dramatic.
Unfortunately, under the new SECURE Act, in most circumstances an inherited IRA must be entirely distributed to the beneficiaries within ten years of the owner’s death. The problem is that distributions from the IRA are considered taxable income. Therefore, instead of paying taxes in small amounts over a lifetime, the beneficiary must pay taxes on the entire account within ten years. For a $1 million IRA, this would mean paying taxes on at least $100,000 of income every year for ten years.
Not only will this mean additional taxable income for your beneficiaries, but it will be taxable income on top of their existing income, often during their highest earning years. This would bump most earners into a higher tax bracket, resulting in the inherited IRA being taxed at a very high rate.
In one sentence: The SECURE Act has transformed the IRA from a relatively good estate planning vehicle to a very poor estate planning vehicle.
This begs the question: What are the alternatives?
After researching the implications of the SECURE Act for the last month or so, I’ve uncovered two options for alternatives to the inherited IRA. (There’s also always an Option 3, which is to do nothing, but that’s not a very good option after all).
Option One: Roth Conversions
The first option is to convert a portion of your traditional IRA to a Roth IRA, ideally on an annual basis. When your heirs eventually inherit a Roth IRA, they’ll still be subject to the ten-year payout schedule of the SECURE Act. But since you already paid taxes on the conversion, the Roth IRA distributions will happen Tax Free. As an added bonus, your heirs will also get an extra ten years of tax free growth after your death.
While you will incur an income tax on the conversion, you can control the amount of the conversions so that they take place according to your own timeline and budget. By making reasonable conversions each year, you can spread the tax over time, and avoid a devastating tax hit to your beneficiaries once you’re gone.
If you are concerned with your heirs’ ability to manage an inheritance, then you can still leave the Roth IRA to a trust for their benefit. However, the terms contained in most preexisting Conduit Trusts (including most of the ones that I’ve drafted) would not be ideal for this circumstance. Therefore, if you’re considering Roth conversions to mitigate the SECURE Act, it’s a great time to revisit your estate planning attorney.
Option Two: Life Insurance
The second option is to use a portion of your IRA to fund a life insurance policy. Specifically, you would make a withdrawal each year from your IRA, pay the taxes on the withdrawal, and then use the proceeds to buy a permanent life insurance policy on you and/or your spouse. The cost to withdraw from the IRA would be identical to the cost of Roth conversions. Similarly, the growth within the policy would be tax-free, as with a Roth.
This approach allows a great deal of flexibility in the structure of the insurance policies. For example, you could own the policies directly and retain control over them, or you could own them trust, which would remove them from your estate for estate tax purposes. Another option would be for your heirs to own the policies directly. Similarly, you could name individuals or a trust as the beneficiary of the policy.
For those concerned about having enough money in retirement, the insurance policy could build a cash value that could be used for retirement income. For others with more savings than they’ll likely need, they could use an Irrevocable Life Insurance Trust (ILIT), which would remove the policy from their estate for estate tax purposes, resulting in further tax savings.
Finally, leaving the policy’s death benefit to a trust would protect it for future generations, without the complex reporting and administration limitations that the SECURE Act would have required for an IRA or Roth IRA.
Of course, the Roth conversion option is viable for almost everyone, whereas life insurance may not make sense, depending on the age and health of the insured. But for anyone with a significant balance within an IRA, it certainly makes sense to discuss these options with your estate planning and financial professionals.
First, don’t panic. Instead, ask yourself three questions:
- Do I have a significant amount of wealth in qualified retirement plans (IRAs, 401(k)s, etc.)?
- Have I done any retirement-account-specific estate planning in the past, like naming a trust as beneficiary, or setting up a conduit or accumulation trust (these come under many names, such as Stretch and Protection Trust, IRA Inheritance Trust, Retirement Plan Trust, etc.)?
- Who should I talk to about this planning?
If you don’t have significant assets within your IRA, then you have nothing to worry about.
If you’ve done IRA specific estate planning, then you almost certainly want to speak with your estate planning attorney to see how these changes impact your plan, as your current trusts may be obsolete. If you haven’t done any IRA specific estate planning, you’re still subject to the new ten-year rule, so it may make sense to analyze your options.
Of course, I am available to discuss your estate planning options. It’s also important to note that the SECURE Act changed many aspects of retirement planning outside of the estate planning context. For this reason, the best planning involves a collaboration between your legal, financial, and tax advisors.
To that end, I’ve developed a network of experienced and trusted attorneys, financial advisors, accountants, and other professionals. Whenever you’re facing a legal or financial challenge, if you need a recommendation for a professional that you can trust, please reach out. Whether it’s related to the SECURE Act, your estate planning, or something completely different, I’d love to hear from you.