No More IRA Stretch From One Generation to the Next
Some people think that their IRA actually belongs to them. It does not. It belongs in part to the government. The politicians created IRA plans. Those who make the rules can change the rules. . . and they do. This principle is made very clear in the SECURE Act. The SECURE Act Estate Plan Update should be carefully considered.
The SECURE ACT (Setting Every Community Up for Retirement Enhancement) became effective federal law as of January 1, 2020. It significantly changes the taxation of qualified plans and individual retirement accounts (collectively “IRA”). This has a big impact on how retirement accounts can and ought to be managed in an estate plan.
Regardless of what any politician may claim, the SECURE Act from beginning to end is a cleverly disguised tax hike. It compels a more rapid distribution from IRA’s, which are taxable, and prevents prolonged deferrals of distributions (which delay taxes). The genius of this move is that it is done in the name of making retirement more secure.
Required Minimum Distributions
The age for Required Minimum Distributions (“RMD’s”) has changed from age 70 1/2 to 72. This is phased in over the next three years. This is advertised as a big break for tax payers. You can decide for yourself it it actually helps you.
The maximum age for contributions to an IRA are eliminated. This means contributions can be made at any age, even after retirement. For what it’s worth, don’t do it. It’s a trap!
No Stretching Allowed
For some time, people structured the IRA’s with the idea that they would leave them to the next generation. The next generation would continue to “stretch” the tax deferral of the IRA for their own lifetime. Special IRA Trusts were created for this purpose. Many warned that such structures were political, and therefore vulnerable to change. This did not deter the unduly optimistic stretch IRA planning. That is all gone now. The possibility of change is now a reality.
The so-called IRA “Stretch” is eliminated. Non-Spousal beneficiaries are required to distribute the entire IRA withing 10 years. This destroys a great deal of past planning. The notion that an IRA is an effective device for delivering wealth to the next generation has been completely debunked. Sorry, but I told you so.
The “10 year rule” does not apply to 1) spousal beneficiaries, 2) surviving minor children, 3) certain disabled beneficiaries, 4) chronically ill beneficiaries, and 5) beneficiaries less than 10 years younger than the IRA owner.
A “Designated Beneficiary” has to be an individual (i.e., natural person). Designated Beneficiaries are subject to the Ten Year Rule.
If the IRA goes to the probate estate, it is not a “Designated Beneficiary” and as a result the IRA must be distributed within five years. This “Five Year Rule” creates an incentive to leave a probate open for the five year period in order to spread out the tax impact of the distributions for the maximum time permitted. This is not a new rule under the SECURE Act. This has long been the rule. It is important to note the importance of naming Designated Beneficiaries to avoid the Five Year Rule.
What About My ROTH?
The SECURE Act makes no significant changes to the rules that govern ROTH IRA’s. However, without the “stretch” the ROTH conversion is no longer as attractive as it once was. The ROTH conversion from a Traditional IRA triggered an immediate tax in exchange for long term tax free distributions. The up-front tax reduction of principal could, in theory, be made up over time. Now, the incentive is to leave the principal working and growing, and continue to defer the ultimate tax obligation until either RMD’s or death compel distributions.
The SECURE Act Estate Plan Update is to strongly consider the private contractual alternatives discussed below.
Should My Trust be a Beneficiary of my IRA?
What if a Trust is the beneficiary of an IRA? Trusts are being named as beneficiaries of IRA’s far more than they should be. This is not because naming a Trust as beneficiary of an IRA is a bad idea. It is because too many Trusts do not have adequate provisions to comply with applicable rules governing IRA distributions. The need for any Trust to have provisions compliance with rules governing IRA’s has not changed. The trouble that arises when a Trust does not have such rules have also not changed.
Under pre-SECURE Act rules a “conduit trust” could be named as a beneficiary, and the life expectancy of the individual would be used to calculate the RMD’s. This would result in “stretching” the IRA and paying taxes over the life expectancy of the beneficiary. Presumably, this is no longer an option because a Trust no longer qualifies as a “Designated Beneficiary” and so, when taking distributions, must pay the taxes. For this reason, many now no longer regard the “conduit trust” as a good idea and have abandoned it altogether.
Abandoning the “conduit trust” is a symptom of poorly drafted Trusts. For example, it is possible to cause income attributed to a Trust to be taxed to a beneficiary instead of the Trust through such devices as “Beneficiary Defective” provisions.
Beyond the tax consequences, there are a number of non-tax reasons for holding IRA proceeds in a Trust that may be more important than minimizing the taxes. These may include Special Needs, Spendthrift, Substance Abuse, business succession, or other dynastic planning concerns.
Should I Update My Trust?
The SECURE Act prompts the appropriate question of whether or not it is appropriate to update or upgrade a Trust to include “dynasty” provisions. Such a Dynasty Trust update may rightfully also include provisions that address IRA and retirement plan distributions in keeping with your goals and concerns. This is again part of what distinguishes “dynasty” planning from traditional estate planning.
If you are going to make a charitable gift at death anyway, the best of all available assets to gift is an IRA. When an IRA goes to a Family Foundation or other charity, it goes dollar for dollar, without any tax. The entire value of the IRA will go to your charitable purpose and the politicians won’t get any of it. This, of course, does not work if the family members need the IRA income to work on. That requires a blended structure.
For some time, a testamentary Charitable Remainder Trust was popular as an IRA beneficiary because it allowed a “stretch” of the IRA income on a tax favored basis. This fell out of favor because of the so-called 10% rule. This rule made CRT’s impractical for younger beneficiaries in particular, because at the point of origin, the CRT had to provide on an actuarial basis at least 10% of the initial contribution for the charitable beneficiary. The difficulty was, of course, that it is almost always impossible to predict when the IRA owner will die, and if the beneficiary is not of sufficient age, the plan can collapse on itself.
With the SECURE Act Estate Plan Update, the CRT option is once again attractive. This is in part because it is perhaps the ONLY way to stretch an IRA on a tax efficient basis. As a technical matter, the problems associated with the 10% Rule can be overcome with appropriate provisions in the CRT document that guarantee that regardless of market performance, not less than 10% of the initial gift will in fact go to the charitable beneficiary. THis is how it works:
The IRA owner forms a CRT with the appropriate savings clause in it.
Upon the owners death, the IRA distributes to the CRT.
The CRT is tax exempt, so it does not directly bear the tax consequences of the IRA distribution.
The CRT pays income to the income beneficiary either for a term of years or for life depending on age
Of course, the tax benefits alone are NOT a sufficient reason to implement a CRT. The IRA owner must have some charitable intent, or it just does not make sense.
Private Contractual Alternatives to IRA’s
It is worth noting that an IRA is a government sponsored retirement plan. There are, of course, private contractual alternatives. One of these is cash rich life insurance. The strategy is simple:
The Trust purchases life insurance. This may be on the IRA owner, or on another family member. Something some life insurance professionals are slow to advise is that the policy will work best when it has a low death benefit and a high cash value.
The Trust pays the premiums on the life insurance.
This is a powerful and beautiful structure that for the right person can completely eliminate taxation on IRA at death, create tax free benefits for the family, and capture funds otherwise confiscated in taxes for charitable purposes.
Should I Update My Beneficiaries?
As you read this article, you had some ideas about what you ought and need to do for your estate planning. Do it. Call or email now for help. That is what we do.