Much has changed in the IRAs in recent years, and more changes will come if the President and the majority in Congress get their way. It is important to reevaluate your strategies.
Here are the most important changes in recent years.
Required Minimum Payouts (RMDs) do not have to start before the age of 72 for anyone turning 72 after December 31, 2019. Contributions to both traditional IRAs and Roth IRAs can be made at any age. Starting in 2022, new life expectancy tables will be used to calculate RMDs, which will slightly reduce the number of RMDs.
However, the most important development for many estate plans is that the Stretch IRA is no longer available.
Most beneficiaries who inherit an IRA after 2019 must distribute the IRA in full 10 years after inheritance. There are only a few exceptions for the so-called eligible Designated Beneficiaries (EDB). EDBs include the surviving spouse, minor children of the deceased IRA owner, the disabled or chronically ill, and beneficiaries no more than 10 years younger than the deceased owner.
The 10 year rule has at least two negative effects on your heirs.
First, the beneficiaries can no longer let the tax deferred compounding of the IRA work for as long as they want. Instead, the IRA must be emptied, taxed, and closed within 10 years.
Remember that the 10 year rule applies to both Roth IRAs and traditional IRAs. Although the Roth distributions are not taxed, the beneficiary loses the benefit of tax-free compounding of future investment income.
Second, the forced distributions can increase the beneficiary’s taxable income within 10 years. The beneficiary is likely to be pushed into higher tax brackets in the years that distributions are inherited from an inherited traditional IRA.
A beneficiary really only inherits the post-tax value of a traditional IRA, and the 10-year rule often reduces the post-tax value of the IRA. In addition, an IRA for inheritance tax purposes is included in the estate. If proponents of lower inheritance tax exemptions get their way, traditional IRAs will likely be lessened by both inheritance and income taxes.
Because of these changes, your IRA plan and estate plan will need to be revised to maximize the benefits and after-tax income from both traditional and Roth IRAs. Review these steps and follow the steps that work best for you.
Reconsider the naming of beneficiaries. Designating your adult children as primary IRA beneficiaries might have been a good idea if the beneficiaries had a lot of flexibility. But it may not be the best move with the 10 year rule.
If your adult children are financially well off, being named as the primary beneficiary could increase their taxable income and push them into higher tax brackets as a traditional IRA is distributed within 10 years.
It may be better to designate your spouse as the primary beneficiary so that there is more time to consider some of the strategies listed below for lowering taxes on the IRA.
Or you would like to name grandchildren as beneficiaries. You won’t fall under the 10-year rule until you are 18 in most states and will likely be in lower tax brackets than you or your adult children.
As I will discuss below, if you are a charity you should consider making charitable gifts, both lifetime and posthumous, through your IRA rather than through other portions of the estate.
Trusts that are IRA beneficiaries need to be reviewed quickly. If you have designated a trust as the beneficiary of your IRA, an estate planner must review the trust immediately. The SECURE Act changed the tax consequences of different types of trusts.
A skilled estate planner can tell you whether another type of trust should be the beneficiary of your IRA or whether you should not designate a trust as a beneficiary.
Look for IRA conversion opportunities. A valuable gift to leave your heirs is paying income taxes from a traditional IRA by converting it into a Roth IRA.
If you left the IRA intact to inherit to your beneficiaries, they would pay the income taxes when the money is distributed. By converting the IRA, you leave them an IRA with tax-free distributions. You paid income tax for them and did not have to take any of your lifetime inheritance and gift tax exemptions or pay any gift or inheritance tax on that gift.
You should review the conversion opportunities at least once a year. Be vigilant for years when your income will be lower than usual or the deductions are higher. Fill that void in taxable income by converting part of the IRA.
Reposition traditional IRAs. An IRA conversion is a way to reposition a traditional IRA.
Another strategy is to convert the traditional IRA into permanent life insurance.
You could distribute the IRA balance as a lump sum, include the amount in gross income, and pay income tax on it. The post-tax amount is used to pay a flat-rate premium for permanent life insurance. The most effective step for a married couple is to take out survivor insurance, which pays out benefits after both spouses die.
Another option is to make a distribution every year and use the post-tax amount to pay the annual premiums for permanent life insurance.
With this method, you avoid a big one-year increase in income, which could push you into a higher tax bracket and also trigger stealth taxes, such as higher taxes on social security benefits and the Medicare premium surcharge.
Whichever way you choose, life insurance benefits are inheritance tax-free. Your beneficiaries receive full life insurance benefits, but when they inherit a traditional IRA, they inherit only after-tax value.
In addition, the amount of the life insurance benefit is guaranteed. Unlike an IRA, the insurance benefit is not subject to market fluctuations, poor investment decisions and other uncertainties.
Many people in good health can use their IRA’s post-tax values to purchase life insurance benefits that exceed their IRA’s current pre-tax values. It would take years of good investment returns to catch up with the tax-free life insurance benefit.
Coordinate your IRA and charity donations. People who make charitable giving should make all or most of their donations after age 70 through Qualified Donations (QCDs) from their traditional IRAs.
A QCD is when money or property is transferred directly from the traditional IRA custodian to a charity at the direction of the IRA owner. Alternatively, the custodian may write a check payable to the charity to the IRA holder, which the owner will give to the charity.
The QCD is not included in the IRA owner’s gross income, but it does count towards the RMD for the year when an RMD is required. QCD can be done anytime after age 70, although RMDs are not required until after age 72.
A taxpayer can make up to $ 100,000 in charitable contributions each year through QCDs. A married couple can create QCDs of up to $ 200,000, but each spouse must give $ 100,000 from their own IRAs.
Make charitable legacies through IRAs. If you are planning to include charitable gifts in your estate plan, it is usually better to give the gifts through a traditional IRA rather than giving estate assets.
Remember, IRA beneficiaries really only inherit the post-tax value of a traditional IRA. But a charity is tax exempt. If a charity is designated an IRA beneficiary and receives a distribution from the IRA, the charity will not be taxed on the distribution. If your estate is large enough to be taxable, the estate will receive a charitable contribution deduction equal to the full value of the IRA amount left for charity.
If your children or other non-charitable beneficiaries inherit assets outside of the IRA, they will increase the tax base of the assets to their current market value under applicable law. You can sell the assets immediately without paying any capital gains tax. The increase in value that occurred while you owned the assets is not taxed.
This is why it is much better for those who are charitable to make their charitable legacies by designating charities as IRA beneficiaries. Do not leave non-IRA assets to charitable beneficiaries.
Repositioning the IRA as long-term care insurance. Most people fear that the cost of future long-term care (LTC) could deplete their net worth. If you have enough income and assets outside of the traditional IRA to maintain your standard of living, repositioning the IRA to pay LTC can provide more money to pay for LTC and still leave a legacy for your heirs when you don’t need the LTC .
A good strategy is to take a payout from the traditional IRA, pay the taxes, and use the after-tax proceeds to purchase permanent life insurance with care benefits. If you need LTC while you are alive, the insurer will transfer you a monthly payment.
One advantage is that the LTC benefits are higher than the amount you pay into the policy. LTC benefits are a multiple of the premium you paid for the insurance, the multiple depending on your age, health, and other factors.
If you intend to use the IRA to pay an LTC, converting the IRA to life insurance with LTC benefits will multiply the amount you have available to pay for the LTC. If it turns out that you do not need a lot of LTC while you are alive, your beneficiaries will receive the amount of the life insurance benefit.
An alternative is to use the after-tax IRA distribution to buy an annuity with LTC benefits. This should provide LTC benefits equal to two to three times the pension balance.
Use a trust with triple benefits. Another strategy for those who are charitable is to use the funds of a traditional IRA to create a nonprofit residual trust (CRT). I don’t have a place here to go into the details of a CRT. However, if you are a charity and want to earn a tax-deferred lifetime income from your traditional IRA, ask your estate planner if a CRT makes sense for you.
There is no single right strategy for everyone. But almost everyone needs to reassess their IRA strategies and adapt to recent tax law changes.