A lot has changed about IRAs in the last couple of years, and more changes are coming if the President and majority in Congress have their way. It’s important to re-assess your strategies.
Here are the key changes of the last few years.
Required minimum distributions (RMDs) don’t have to begin until age 72 for anyone who turns 72 after December 31, 2019. Contributions to both traditional IRAs and Roth IRAs can be made at any age. New life expectancy tables will be used to compute RMDs beginning in 2022, slightly reducing the amount of RMDs.
But the most important development for many estate plans is that the Stretch IRA no longer is available.
Most beneficiaries who inherit an IRA after 2019 have to fully distribute the IRA 10 years after inheriting. There are only a few exceptions for what are known as eligible designated beneficiaries (EDBs). EDBs include the surviving spouse, minor children of the deceased IRA owner, the disabled or chronically ill, and beneficiaries not 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 no longer can 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, the 10-year rule applies to Roth IRAs as well as traditional IRAs. Though the Roth distributions aren’t taxed, the beneficiary loses the advantage of tax-free compounding of future investment income.
Second, the forced distributions within 10-years can cause spikes in the beneficiary’s taxable income. The beneficiary is likely to be pushed into higher tax brackets in the years when distributions are taken from an inherited traditional IRA.
A beneficiary really inherits only the after-tax value of a traditional IRA, and the 10-year rule often will reduce the after-tax value of the IRA. In addition, an IRA is included in the estate for estate tax purposes. If the proponents of a lower estate tax exemption have their way, inherited traditional IRAs are likely to be diminished by both estate and income taxes.
Because of these changes, your IRA plan and estate plan need to be revised to maximize the benefits and after-tax income from both traditional and Roth IRAs. Review these steps and take those that work best for you.
Reconsider beneficiary designations. Naming your adult children as primary IRA beneficiaries might have been a good idea when beneficiaries had a lot of flexibility. But it might not be the best move with the 10-year rule in place.
If your adult children are doing well financially, naming them as primary beneficiaries could cause spikes in their taxable income and push them into higher tax brackets as a traditional IRA is distributed within 10 years.
It might be better to name your spouse as primary beneficiary so there is more time to consider some of the strategies below to reduce taxes on the IRA.
Or you might want to name grandchildren as beneficiaries. They won’t be under the 10-year rule until after they turn 18 in most states and are likely to be in lower tax brackets than you or your adult children.
As I discuss further below, if you’re charitably inclined consider making both lifetime and posthumous charitable gifts through your IRA instead of other parts of the estate.
Trusts that are IRA beneficiaries need to be reviewed quickly. If you named a trust as beneficiary of your IRA, an estate planner needs to review the trust right away. The SECURE Act changed the tax consequences of different types of trusts.
An experienced estate planner will be able to tell you if a different type of trust should be the beneficiary of your IRA or if you shouldn’t name a trust as beneficiary.
Look for IRA conversion opportunities. A valuable gift to leave your heirs is to pay the income taxes on a traditional IRA by converting it to a Roth IRA.
If you left the IRA intact to be inherited by your beneficiaries, they would pay the income taxes as money is distributed. By converting the IRA, you’re leaving them an IRA with tax-free distributions. You paid the income taxes for them and didn’t have to use any of your lifetime estate and gift tax exemption or pay gift or estate taxes on that gift.
You should review conversion opportunities at least annually. Be alert for years when your income is going to be lower than usual or deductions will be higher. Fill that gap in taxable income by converting part of the IRA.
Reposition traditional IRAs. An IRA conversion is one way to reposition a traditional IRA.
Another strategy is to convert the traditional IRA to permanent life insurance.
You could distribute the IRA balance as a lump sum, include the amount in gross income, and pay income taxes on it. The after-tax amount is used to pay a lump sum premium for a permanent life insurance policy. The most effective step for a married couple is to buy a survivorship policy that pays benefits after both spouses pass away.
Another option is to take a distribution each year and use the after-tax amount to pay annual premiums on a permanent life insurance policy.
With this method you avoid a large one-year spike in income that 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 surtax.
Whichever way you choose, the life insurance benefits are a tax-free inheritance. Your beneficiaries will receive the full life insurance benefit, but if they inherit a traditional IRA they inherit only the after-tax value.
In addition, the life insurance benefit amount is guaranteed. Unlike an IRA, the insurance benefit isn’t subject to market fluctuations, bad investment decisions, and other uncertainties.
Many people in good health are able to use the after-tax values of their IRAs to buy life insurance benefits that exceed the current pre-tax values of their IRAs. It would take years of good investment returns to catch up with the tax-free benefit the life insurance would provide.
Coordinate your IRA and charitable giving. People who make charitable gifts should make all or most of their gifts after age 70½ through qualified charitable distributions (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 can give the IRA owner a check made payable to the charity, which the owner delivers to the charity.
The QCD isn’t included in the IRA owner’s gross income, yet it counts toward the RMD for the year, if an RMD is required. A QCD can be done anytime after age 70½, though RMDs aren’t required until after age 72.
A taxpayer can make up to $100,000 of charitable contributions through QCDs each year. A married couple can make QCDs of up to $200,000, but each spouse must give $100,000 from his or her own IRAs.
Make charitable bequests through IRAs. When you plan to include charitable gifts in your estate plan, it’s usually better to make the gifts through a traditional IRA instead of giving estate assets.
Remember that IRA beneficiaries really inherit only the after-tax value of a traditional IRA. But a charity is tax-exempt. When a charity is named IRA beneficiary and takes a distribution from the IRA, the charity isn’t taxed on the distribution. If your estate is large enough to be taxable, the estate receives a charitable contribution deduction for the full value of the IRA amount left to charity.
When your children or other noncharitable beneficiaries inherit non-IRA assets, under current law they increase the tax basis of the assets to their current fair market value. They can sell the assets right away without owing capital gains taxes. The appreciation that occurred while you held the assets isn’t taxed.
That’s why it’s far better for those who are charitably inclined to make their charitable bequests by naming charities as IRA beneficiaries. Leave non-IRA assets to non-charitable beneficiaries.
Reposition the IRA as long-term care insurance. Most people worry the cost of future long-term care (LTC) might deplete their estates. When you have enough income and assets outside the traditional IRA to sustain your standard of living, repositioning the IRA to pay for LTC can provide more money to pay for LTC and still leave a bequest for your heirs if you don’t need the LTC.
A good strategy is to take a distribution from the traditional IRA, pay the taxes, and use the after-tax proceeds to buy permanent life insurance with long-term care benefits. If you need LTC during your lifetime, the insurer will send you a monthly payment.
One advantage is that the LTC benefits will be more than the amount you put into the policy. The LTC benefits will be a multiple of the premium you paid for the insurance, with the multiple depending on your age, health, and other factors.
If you were planning to use the IRA to pay for any LTC, converting the IRA to a life insurance policy with LTC benefits multiplies the amount you have available to pay for LTC. If it turns out that you don’t need much LTC during your lifetime, your beneficiaries receive the life insurance benefit amount.
An alternative is to use the after-tax IRA distribution to buy an annuity with LTC benefits. This should provide LTC benefits of two to three times the annuity balance.
Use a trust with triple benefits. Another strategy for those who are charitably inclined is to use the balance of a traditional IRA to establish a charitable remainder trust (CRT). I don’t have space here to discuss the details of a CRT. But if you’re charitably inclined and want to generate tax-advantaged lifetime income from your traditional IRA, ask your estate planner if a CRT makes sense for you.
There’s no one right strategy for everyone. But almost everyone needs to re-assess their IRA strategies and adjust for them for the recent tax law changes.
