Overview
Rachel Moran and Brent Zackon discuss changes in the distribution of IRAs inherited by non-spouse beneficiaries following the SECURE Act and present a case study designed to demonstrate the impact of utilizing Roth Conversions to increase a beneficiaries’ post-tax inheritance. Watch this webinar if you’re interested in learning about the following:
- The impact of the SECURE Act on distributions from inherited IRAs
- How a beneficiary’s tax rate effects their net inheritance
- How the SECURE Act condenses taxation of the IRA and decreases the beneficiary’s net inheritance
- How Roth conversions can help offset the loss of the Stretch IRA and encourage generational wealth transfer
- Considerations in implementing Roth conversions
- Who is best suited for pursuing generational wealth transfer
Transcript
Brent:
Thank you for joining us today. My name is Brent Zackon. My colleague, Rachel Moran, and I will be discussing ways to maximize the post-tax value of your inheritance, following the passage of the SECURE Act.
Rachel:
The SECURE Act, which stands for Setting Every Community Up for Retirement Enhancement, was passed into law on December, 2019. It focused on aiding Americans’ ability to save for retirement; establishing more favorable rules related to IRAs and qualified plans. One not so favorable provision we will be discussing today, is the loss of the stretch IRA.
Before we begin, let’s review a few main concepts related to IRAs. IRAs are tax deferred accounts. So, the account owner receives a tax deduction upon funding and distributions from the account are taxable upon withdrawal. IRAs are subject to what’s called, Required Minimum Distributions (RMDs), which are minimum amounts that the owner must withdraw annually beginning at age 72.
Prior to the Secure Act, non-spouse beneficiaries of IRAs were also subject to RMDs and could actually stretch these distributions over their lifetime. Now, these proportionately small distributions allowed the account to continue growing on a text deferred basis, therefore resulting in a valuable retirement asset for the beneficiary.
Under the SECURE Act, non-spouse beneficiaries must fully distribute inherited IRAs within 10 years of the passing of the original account owner. There are no minimum distributions within this timeframe. The non-spouse beneficiary could withdraw nothing for the first five years, but would then be required to remove the entire balance in the 10th year.
It’s important to point out that these new rules apply only for IRAs inherited in or after 2020. Those who inherited an IRA in 2019 or prior, are grandfathered and can continue distributing according to the old stretch IRA rules.
It’s also important to point out that certain eligible designated beneficiaries, including spouses, disabled, or chronically ill individuals, or those not more than 10 years younger than the decedent, and finally, minor children of the original account owner will still be permitted to stretch distributions. Once minor children reach the age of 18, however that 10-year rule will commence. IRAs inherited by non-spouse beneficiaries must be entirely distributed and taxed within 10 years, following the year of the original account owners passing.
Now, this next slide really helps illustrate the changes and distribution options for a non-spouse beneficiary. The first column contains the account holders RMD pre-SECURE Act. Now, to calculate the client’s RMD, you would divide the previous year in balance by a factor. Inherited IRAs references called, the single life expectancy table, and that initial factor is reduced annually by one.
So in this case, a million dollar IRA inherited by a 60 year old individual, had that client’s initial factor as 25.2, which would result in an RMD of about $40,000. Now, assuming no growth, the value of the RMD is actually static. And at the end of 10 years, the client would have taken just about $400,000 out in required minimum distributions.
The four subsequent columns illustrate the flexibility afforded albeit at a cost of the SECURE Act. The beneficiary can either withdraw the balance of the account in year one, withdraw the balance of the account evenly over 10 years, withdraw the balance of the account in year 10, or withdraw the balance of the account in irregular lump-sum distributions overlap 10 years.
Regardless of the method chosen, the entire account balance must be distributed within 10 years, following the year of death of the original account owner, that’s a significant change. As you can see, the total required withdrawals are much higher post SECURE Act, $1 million versus $400,000, which signifies increased taxable income for the beneficiary. Additionally, that beneficiary is no longer benefiting from the tax deferred growth associated with an IRA, everything has been distributed from the account.
Brent:
Now, let’s consider the full impact of the SECURE Act on a beneficiary’s inheritance. We’ve developed a case study to illustrate a few concepts, and highlight how you might be able to increase your beneficiary’s post-tax inheritance using Roth conversions.
In this example, Bob and Mary are 60 years old, they have a $3 million joint investment account, and Mary has a $2 million IRA. Their investments are allocated 60% stocks, 40% bonds. Bob and Mary spend $215,000 per year and expect to receive $4,000 per month in social security income at full retirement age. They will pass at age 90, giving their assets to their two children. Their children, Tom and Julie, will be 60 at the time of their passing, and in the 22% tax bracket. Through our financial planning projections, we have determined that Bob and Mary have sufficient assets for their lifetime. They are interested in and can afford to pursue strategies to maximize the inheritance received by their children.
In this example, prior to the SECURE Act, Bob and Mary pass away with about $6.3 million, that’s divided with 160,000 in their joint investment account, and 6.1 million in Mary’s IRA. Prior to the SECURE Act, their kids could stretch distributions from the IRA over their lifetime. At an initial factor of 25.2, each child’s first required minimum distribution would be about $122,000. This increase in income pushes them into the 24% tax bracket. Net of taxes, Tom and Julie would receive about 4.8 million in total.
Following the passage of the SECURE Act, Bob and Mary still pass away with 6.3 million divided up as 160,000 in their joint investment account, and 6.1 million in Mary’s IRA. But now, after the passages of the SECURE Act, their kids can no longer stretch distributions from the IRA over their lifetime. They must withdraw the balance of the IRA within 10 years. Assuming they choose to withdraw the balance of the IRA evenly every 10 years, their annual distribution would be about $308,000 per person; now pushing them up into the 35% tax bracket. This annual distribution is almost $200,000 more than the RMD they were subject to prior to the passage of the SECURE Act. The biggest takeaway here is that you can see how the loss of the stretch IRA results in a more condensed taxation of the IRA. This increase in ordinary income pushes Tom and Julie into a higher tax bracket, going from 24% to 35%, costing 679,000 in after-tax inheritance to them.
Rachel:
How might we maximize the value of Tom and Julia’s inheritance? One option might be Roth conversions. A Roth conversion is the taxable transfer of assets from a traditional IRA to a Roth IRA. As we mentioned, traditional IRAs are funded with pre-tax income and taxed when the funds are withdrawn. Well, Roth IRAs are funded with after-tax income and are tax-free upon withdraw.
So, first we’ll consider the implementation of a single Roth conversion. Assume Bob and Mary decide to implement a $1 million Roth conversion, which pushes them into the highest tax bracket in that year of conversion. In the time between the Roth conversion and Bob and Mary’s passing, they actually spend down their entire joint investment account, as well as Mary’s IRA. While Mary’s Roth IRA, with the initial $1 million conversion actually grows to $4.9 million.
Upon Bob and Mary’s passing, Tom and Julie inherit that $4.9 million Roth IRA. While they still must withdraw the balance within 10 years, those distributions are not taxable. So, the after-tax value to Tom and Julie is just that the $4.9 million. The key takeaway here is that, despite having the $1 million Roth conversion taxed at the highest rate, the subsequent tax-free growth during Bob and Mary’s lifetime actually results in an increased after-tax inheritance for Tom and Julie. The total assets are less $4.9 million compared to the $6.3, however the after-tax value, is actually $778,000 higher.
Brent:
Now instead of one single Roth conversion, we’ll consider implementing multiple Roth conversions over a number of years. In this case, Bob and Mary choose to implement multiple Roth conversions, converting $50,000 per year for 10 years, so $500,000 in total. Therefore when Bob and Mary pass, Tom and Julie inherit a $3.1 million IRA and a $2.8 million Roth IRA. Tom and Julie must withdraw the balance of the IRA and the Roth IRA within 10 years, but only the IRA will be taxable.
Assuming they choose to withdraw the balance of the IRA evenly over 10 years, their annual distribution would be about $156,000 per person, pushing them into the 32% tax bracket. Some of the biggest takeaways are by converting to a Roth IRA gradually at lower tax rates, the after-tax value of the inheritance increased by 65,000 relative to the single Roth conversion, despite converting $500,000 less in total. And, Tom and Julie actually received more in this scenario over the pre SECURE Act scenario as Bob and Mary are implementing multiple Roth conversions within their tax bracket, which in this case is lower than Tom and Julie’s resulting in a net increase in post-tax inheritance.
Rachel:
As you can see, in looking at the summary of scenarios, Roth conversions definitely helped increase Tom and Julie’s post-tax inheritance value. Now, we’d find similar results if Bob and Mary began processing those Roth conversions at age 70. Well, the numbers might not be quite as compelling since there’s few years of tax-free growth, you’ll still be reducing the impact of that compressed income at Tom and Julie’s tax rates.
It’s also important to note that this entire analysis really hinges on tax rate assumptions. You know, what’s the rate at which you’re converting assets draw today, versus the rate at which your children will pay on distributions from an IRA 20+ years down the road. It’s very hard to say, and it’s somewhat of an art and science, and accounting for your own needs while also considering your desire for generational wealth transfer.
In practice, we’ve been implementing Roth conversions for a number of clients following retirement when their income might be reduced prior to the commencement of RMDs. And that strategy, especially makes sense if their children are high income earners and likely going to be in a higher tax bracket than they would currently upon conversion.
Brent:
There are a few items to consider if you want to implement either a single or multiple Roth conversion.
- The first one, you must be comfortable with paying taxes on behalf of beneficiaries.
- The second, as Rachel mentioned, you have to balance the tax brackets, meaning there’s an uncertainty of future tax rate with the current certainty of a low tax rate environment. So, you have to weigh your bracket versus your child’s tax bracket.
- Number three, performing some of these Roth conversions may or may not trip income related thresholds, such as the Medicare IRMAA or state tax nuances, depending on the state. So, it’s important to determine how much you want to convert with this tax planning. And finally, there’s the taxable state reduction, meaning that traditional IRAs will always be subject to income tax, whether in your estate or your child’s estate. In the event, your estate is subject to estate tax prepayment of those income taxes by way of these Roth conversions, could reduce the value of your taxable estate, thereby reducing estate taxes.
Now, some additional changes to IRAs following the SECURE Act, include the age at which required minimum distributions must begin. This increased from age 70 and a half up to now age 72. So, this gives any IRA holders, one to two years of additional tax deferral, a longer runway to process Roth conversions before that forced income begins, and allowing qualified charitable distributions for any individuals, age 70.5 and older.
A Qualified Charitable Distribution (QCD) is a distribution from your traditional IRA directly to a qualified charity. These are counted towards satisfying your RMD for the year, and they’re not taxable income to the account owner. Additionally, the age at which IRA contributions are allowed, has now increased. You’re allowed to do that beyond age 70 and a half. And with the passing of the secure act Trusts as IRA beneficiaries should be evaluated because of the distribution language. Since RMDs in the traditional sense are no longer required on non-spouse inherited IRAs we recommend revisiting instances where a trust is a beneficiary of an IRA.
Rachel:
Absolutely. So we, we hope this presentation has helped illustrate the way in which Roth conversions might be able to increase your beneficiaries’ post-tax inheritance. The main takeaway that we’ll leave you with is that every situation is unique.
Utilizing Roth conversions for the benefit of your beneficiaries should really only be considered once you have confidence in your own situation. Most importantly, we recommend you work with a financial planner to ensure that this strategy is considered in light of your goals and resources.
Thank you all for your time. Please don’t hesitate to reach out to Brent or myself with any questions, we’ve included our contact information here. We do look forward to sharing additional opportunities related to the secure act with you soon. Thank you very much.
Brent:
Thank you so much.