The SECURE Act, passed and signed into law in the waning days of 2019, upended traditional legacy planning relating to retirement plans. Since these never-taxed assets account for the bulk of most Americans non-real estate wealth, this is a big deal. For many, it’s a game changer that will result in a major tax hit if you don’t adjust.
Prior to this new “security,” the straightforward strategy for most Americans was simply to live off their IRAs and other retirement plans, paying taxes as they withdrew the funds. When a person no longer needed the money—that is, they needed an undertaker—the accounts could pass to the next generation. The key is that beneficiaries had the option to withdraw the funds over their life expectancy. This continued slow use of the funds allowed them to grow as well as smooth out the taxes paid. The slang for this strategy was “stretching” the IRA.
Death of a Tax Strategy
The SECURE ACT killed the stretch IRA for non-spouses, replacing it with a ten-year-and-out rule for people who inherited in 2020 going forward. There are no longer any required annual withdrawals, but the entire account must be emptied in ten years. If not, half the account plus taxes will head to DC.
Consider a $1 million IRA transferring to a 50—year old child. Under the old rules, she’d have to withdraw just over $29,000 in the first year after mom’s death. Over ten years, given a 6 percent rate of return, she’d withdraw $442,000. If the beneficiary had a household income of $150,000, she would pay just over $100,000 in taxes over a decade with plenty more to come in the future.
The account balance at that point would be $1,292,683. By her life expectancy at 84 she would have turned the $1 million of initial value into $3.6 million of withdrawals. She’d pay $950,000 in taxes. Seemed like a good deal for everyone, save mom, of course, who had to die for it.
The New Reality
Post-Secure Act, if she elected to take $100,000 out a year and the gains in year 10, she’d pay $378,000 in taxes – $278,000 more. The withdrawals would also move her up the tax brackets, eventually right to the top. If she waited until year ten, she’d withdraw $1.7 million and pay $590,000 in federal taxes. A loss of more than a third of the account.
Although customized inheritance planning was always advisable, the death of the stretch IRA makes it imperative for people who want to maximize money to family. I was struck by this recently when reviewing with a client his substantial IRAs. He and his wife live in a zero-tax state. They are practicing the planning of plentitude. They will likely leave substantial IRA inheritance to their three sons.
Three Sons, Three Strategies
This couple has an above average, if not burning, desire for their hard-earned money to benefit their boys. One son is a high earning executive. One earns an above-average income in a two-income household. The third is a bit of a free spirit and let’s just say income taxes are not a concern at this point. Each of the boys lives in a state that taxes income.
To optimize the after-tax value of the IRAs, we developed the following strategy for the $300,000 of funds that he and his wife knew they were not going to need for their own support.
The First Strategy
For the high earning son’s third of the inheritance, my clients would create an IRA and convert it to a Roth. This would create a taxable event of $24,000 for my clients, as it put them in the 24 percent bracket. I said send the bill to your son. He pays the $24,000 out of pocket. This is far lower than his combined tax rate of 44 percent. He has effectively bought out the IRS’s interest in his inheritance. The $100,000 now compounds for thirty years. You live 20 years and then there’s 10 years before it must be withdrawn. That $24,000 today generates $575,000 of tax-free money in the future.
Although customized inheritance planning was always advisable, the death of the stretch IRA makes it imperative for people who want to maximize money to family. I was struck by this recently when reviewing with a client his substantial IRAs. He and his wife live in a zero-tax state. They are practicing the planning of plentitude. They will likely leave substantial IRA inheritance to their three sons.
Three Sons, Three Strategies
This couple has an above average, if not burning, desire for their hard-earned money to benefit their boys. One son is a high earning executive. One earns an above-average income in a two-income household. The third is a bit of a free spirit and let’s just say income taxes are not a concern at this point. Each of the boys lives in a state that taxes income.
To optimize the after-tax value of the IRAs, we developed the following strategy for the $300,000 of funds that he and his wife knew they were not going to need for their own support.
The First Strategy
For the high earning son’s third of the inheritance, my clients would create an IRA and convert it to a Roth. This would create a taxable event of $24,000 for my clients, as it put them in the 24 percent bracket. I said send the bill to your son. He pays the $24,000 out of pocket. This is far lower than his combined tax rate of 44 percent. He has effectively bought out the IRS’s interest in his inheritance. The $100,000 now compounds for thirty years. You live 20 years and then there’s 10 years before it must be withdrawn. That $24,000 today generates $575,000 of tax-free money in the future.
Michael Lynch CFP is a financial planner with the Barnum Financial Group in Shelton CT and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. He can be reached at mlynch@barnumfg.com or 203-513-6032.
Securities, investment advisory and financial planning services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to complete or cover every situation, and should not be construed as legal, tax or accounting advise. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. CRN202304-282065