The recently passed SECURE Act brings significant changes to retirement accounts. In particular, the repeal of a popular estate-planning strategy may change the way that many people treat retirement assets in their legacy plans.
Under the SECURE Act, individuals who planned to use a “stretch” distribution strategy for individual retirement accounts (IRA) and defined contribution plan assets will need to rethink that strategy. As of the end of 2019, most non-spousal beneficiaries will be required to fully distribute inherited account balances by the end of the 10th year, following the death of the account owner.
There is no requirement for annual distributions, the account just has to be fully distributed by the end of the 10th year, following the year the account owner dies.
Heirs will no longer be able to "stretch out" the tax advantaged savings of an IRA for a period defined by their own life expectancy.
The 10-year time limit to drawdown the account could mean “bracket creep” and a higher tax liability for heirs.
Under the old rules, an heir’s life expectancy could mean a significant tax benefit, provided that the beneficiary did not choose to distribute the inherited account sooner.
Planning strategies in light of the new 10-year rule
For IRA owners
Consider beneficiary designations
- Designate beneficiaries who are more likely to be in lower ordinary income tax brackets and leave other assets (after-tax assets, Roth assets, or appreciated assets that may benefit from stepped-up cost basis at death) to heirs who are more likely to be in higher tax brackets. This strategy could be reviewed periodically to see if adjustments or changes to beneficiary designations are needed.
- Expand the number of beneficiaries on the account, which would spread the IRA income (assuming pretax, not Roth) to more heirs. For example, for two heirs, income distributed from an inherited account could conceivably be “spread” across a total of 20 tax returns, while income from five beneficiaries could be reported across 50 tax returns (5 heirs x 10 years).
- Leave the funds to a spouse who is considered an eligible designated beneficiary (EDB) and is allowed to stretch distributions based on his/her life expectancy.
- Reconsider how much is left to much-younger beneficiaries, such as grandchildren, where the tax-deferral benefit is diminished under the new rules.
- Convert a traditional IRA to Roth while living. Heirs are still subject to the 10-year rule but funds are generally distributed tax-free. It may make more sense if the account owner is in a lower tax bracket than projected for the beneficiary.
- Spend more of the IRAs while living and leave other assets (after-tax) to heirs, or utilize qualified charitable distributions to satisfy charitable giving while drawing down IRAs tax free.
- Consider alternative, advanced strategies such as leaving an IRA to a charitable remainder trust (CRT) or use IRA assets to fund permanent life insurance premiums.
- An IRA can be transferred to a CRT, tax-free at death, if the trust is named beneficiary of the IRA. Heirs receive payments from the CRT per terms of the trust, which can be longer than 10 years.
- If structured properly, life insurance can provide income and estate tax-free proceeds to heirs.
For IRA beneficiaries
Tax-efficient timing of distributions
- Make the best “use” of the 10-year period. For some taxpayers, that may mean spreading income out evenly. Others may want to take larger distributions in certain years where it makes sense from a tax perspective. For example, if the taxpayer is in a lower tax bracket and has more deductions like charitable gifts, that can offset income from IRA distributions
- For heirs of Roth accounts, unless funds from distributions are needed for current expenses, it may make sense to wait until the 10th year to distribute the account. By retaining more funds in the Roth account, these assets could potentially grow tax-free.
With significant changes across retirement accounts, individual investors may consider the importance of seeking professional advice from their financial advisor or tax professional. Investors will want to review existing retirement and estate plans with an advisor to ensure that they are on track to meet their goals. Consulting a legal expert may also be important if an investor is considering advanced planning strategies such as trusts.For more details on the SECURE Act and its impact on retirement accounts and tax planning, read Putnam’s investor education piece, “Understanding the SECURE Act and its implication on planning.”
Advisors can join me and my colleague and Chris Hennessey on February 13 when we will be live discussing the SECURE Act and taking your questions on planning implications. Register for the event here.
For informational purposes only. Not an investment recommendation.
This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Putnam does not provide tax or legal advice.