For as long as I can remember, the stock advice about IRAs has been to stretch them out as long as possible, even to the extent of depleting non-retirement accounts first. This was done to increase wealth, especially for future generations. It has always been important to make sure that your IRA beneficiary designations properly reflect your objectives. With the December 2019 passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, all your prior planning needs to be re-evaluated.
One important provision of the Act is that the age at which Required Minimum Distributions (RMDs) must start has been moved from 70½ to 72. If you weren’t 70½ by December 31, 2019, then you won’t have to start your RMD until you are 72. This will give you some added time to defer income recognition and could offer more planning opportunities to produce tax savings through Roth conversions and other income recognition strategies.
A very significant change is that the SECURE Act effectively eliminates stretch IRAs for non-spouse beneficiaries, forcing them to drain inherited IRAs within 10 years instead of throughout their IRS table life expectancies. Some exceptions to this are when a beneficiary is disabled or chronically ill, is less than 10 years younger than the deceased owner, or while a minor is under the age of majority, typically 18.
Typically, advisors have focused almost exclusively on bracket management as the tactic to evaluate if, and when, to convert Traditional IRAs to Roth. We also typically advised that the Roth assets would be the last asset to be spent during one’s lifetime because those who inherited the Roth would also enjoy tax-free growth and tax-free distribution. The plan has typically been to convert traditional retirement assets to Roth IRAs during low tax years, e.g. between retirement and age 70; and then to pass on Roth assets to future generations permitting those beneficiaries to enjoy tax free income later. A more strategic approach is now mandatory if you want to capitalize on preserving and prolonging wealth. This is especially true if you have rather large retirement accounts relative to your non-retirement accounts. Prior plans should be re-evaluated in light of the new law.
First let’s think about our current tax regime. The lower rates enacted by the Tax Cuts and Jobs Act of 2017 are expected to sunset at the end of 2025, and the higher 2017 rates will then be restored under current law. It is worth noting that the top of the current 24% bracket for married taxpayers filing jointly will be squarely in the middle of the 33% bracket when the current rates go back to 2017 rates. This will become a critical decision factor as you plan for a Roth conversion.
SECURE basically requires all IRAs, Roth IRAs, and Qualified Plans to be distributed within 10 years of the death of the account holder. This can become a significant acceleration of income if non-spouse beneficiaries (typically children or grandchildren) are relatively young. That problem is made worse if they are in a mid-level or higher tax bracket since the distribution will simply be tacked on top of their other income and taxed at their highest tax bracket. Of course, traditional IRA distributions can be tactically withdrawn to manage tax rates. ROTH distributions after death should generally be deferred until the very end of the 10-year period. This is what our friend, Bob Keebler, calls “The Roth Reprieve.”
The positive impact of the 10 years of deferral should not be taken for granted. Growth throughout that period remains tax exempt. Furthermore, there is no required minimum distributions at age 72 for a Roth providing a considerable advantage to the Roth IRA holder in many circumstances. Roth conversions will likely still make a lot of sense for many of you despite the 10-year distribution period.
As you evaluate whether a Roth conversion is beneficial, it is important to consider more than simple bracket arbitrage. Critical decision factors include:
The tax rate differential is a key concern but even that can be more complex than it first appears. For example, the survivor of joint taxpayers becomes a single taxpayer with a much higher rate than when both were still living. Furthermore, conversion of inherited IRAs is not permitted.
The ability to pay the taxes on conversion with “outside funds” is a key consideration and will significantly enhance the total benefit of conversion.
The need for IRA funds to meet annual living expenses.
No RMDs on Roth vs. RMDs on Traditional IRAs.
The time horizon of beneficiaries.
Estate tax considerations.
Tax-free post-mortem distributions of qualified Roth distributions.
The existence of charitable deduction carryforwards, investment tax credits, net operating losses (NOL carryforwards), or high basis nondeductible traditional IRAs.
The ten-year Roth Reprieve.
Charitable intent and use of trusts.
Life insurance considerations to pay taxes.
If any intended beneficiary is disabled or chronically ill, special consideration, such as trust planning, should be a factor.
Prior plans should be re-evaluated in light of the SECURE Act.
The SECURE Act opens up other considerations for tax planning. It gives life insurance a boost as an estate and tax planning vehicle for the largest IRAs. You might be hearing from your life insurance agent soon. IRA trusts got demoted. Careful consideration should be given to cost of insurance; it is possible to replace the lost benefits with life insurance.
A final note: If you or a family member doesn’t currently have a Roth, you might want to consider starting one, even a small one. That will start the 5-year mandatory holding period for all Roths by that owner in order for a distribution to be a “qualified distribution” and therefore exempt from tax and a 10% early withdrawal penalty if the owner is under 59½. More to come on that in a future article.
Scott Neal is president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Send your questions to scott@dsneal.com or call 1-800-344-9098.