Take a Closer Look to Enhance Benefits and Avoid Pitfalls
Jeff Saccacio, CPA, PFS, ChFC, TEP
Head of Wealth Planning + Family Office Services
“The Lord gives and the Lord takes away, as it pleases him, because he can do all things”
- Homer, Greek author, intellectual and philosopher
So does The Setting Every Community Up for Retirement Enhancement Act of 2019 – also known as the “SECURE ACT”. In it the federal government both gives and takes away, with the latter laying traps for the unwary – arguably making things less secure in some respects.
Let’s look at the good news, bad news, and planning that can be done to bolster and enhance your wealth plan.
Prior to the SECURE ACT (“SECURE”) an individual was required to start taking required minimum distributions from individual retirement accounts (i.e. “RMD”) beginning April 1st of the year following the year in which he/she reached age 70 ½. Failure to do that resulted in a 50% excise tax on the shortfall. Qualified plans vary slightly, with distributions of the entire plan balance or RMD to occur at that point. Generally, SECURE changes that age to 72. So now anyone born after June 30, 1949 is not required to take RMD until April 1st of the year after the year in which they turn 72. Good news in that it allows more years of tax deferred growth. It should be noted, the recently passed Coronavirus, Relief and Economic Security Act (“CARES”) waives required minimum distributions otherwise required to be made in 2020.
SECURE removed the prohibition on contributions to a traditional IRA in the year an individual turned age 70 ½ and beyond. Starting in 2020, such contributions are no longer prohibited. Interestingly, prior to SECURE a traditional IRA was the only retirement vehicle with this limitation.
Pre SECURE law allowed individuals to establish and fund an IRA (including SEP-IRA) after year end, but prior to the due date for filing the return (not includingextensions) to get a deduction for that year. While this is normally by April 15th following the close of the tax year, CARES and related government notices extend this to July 15,, 2020 for the 2019 tax year. This provides a post year-end method of reducing one’s tax liability andsaving for retirement. However, businesses (large or small; incorporated or unincorporated) could not do the same with a qualified plan. These plans had to be established prior to year-end in order to get a deduction for the year in question. Starting in 2020 SECURE allows a qualified plan to be established and funded post year-end up until the due date of the return (including extensions).
By far the biggest headline of SECURE is its post 2019 disruption of the bedrock estate planning strategy for tax-advantaged retirement plans – the ability to stretch out the distribution and taxation of inherited IRA and/or plan balances over the life expectancies of Designated Beneficiaries (“DBs”). DBs include individuals and certain trusts (known as “Conduit Trusts”). Use of Conduit Trusts protect the account balance from beneficiary impropriety or creditor/predator claims while mandating the flow though of these required minimum distributions (RMDs) otherwise receivable with outright beneficiary designations.
SECURE effectively puts an end to the “Stretch IRA” eliminating the ability to defer payment of tax and continue tax-free growth of retirement plan balances for substantial periods of time (i.e. until distributed). The impact of this change cannot be undersold – it not only changes prospective retirement plan distributions, but it impacts untold numbers of distribution elections and estate planning documents currently in place. If not addressed, many will be surprised with unintended distributions in both timing and amount.
With certain exceptions, SECURE requires all IRA or retirement plan assets to be distributed by the end of the 10th calendar year following the death of the IRA owner or plan participant. It does not require payments to be made periodically over the 10-year period as long as the entire balance is paid out by the end of the period (although payments certainly can be made beforehand). There are exceptions to the 10-year payout rule which still allow for payments to be made over the life expectancy of any one of 5 Eligible Designated Beneficiaries(“EDBs”).
§ Surviving spouse of the IRA owner or plan participant
§ Defined chronically ill heirs
§ Defined disabled heirs
§ Persons 10 or fewer years younger than the IRA owner or plan participant
§ Minor children of the IRA owner or plan participant, but only until they reach the age of majority (after which the 10-year rule kicks in)
So left unaddressed, an individual could wind up leaving unanticipatedly large distributions to heirs as RMDs over 10 years (outright or via a Conduit Trust), or worse in one very large lump sum at the end of 10 years – not what was envisioned or desired.
What’s a Person to Do?
There are several things you can consider to avoid surprises and unexpected consequences of SECURE.
§ Revisit you beneficiary designations and estate planning documents: Understand your distribution framework and what was intended. Who are the beneficiaries? How and over what period did you want to distribute IRA or plan balances? Are there any circumstances (e.g. financial inexperience, substance abuse or creditor problems) you were planning around? What planning vehicles are you using (e.g. Conduit Trusts)?
Next, assess how SECURE changes this. Do its changes requiring full payout in 10 years or less cause you pain or vary dramatically from your plan? For example, does it put too much money in the hands of someone before they are ready to handle it or at a time when it is unnecessarily exposed to creditors? If so reformulation, redrafting and revision of documents and beneficiary elections need to occur.
§ Consider using an Accumulation Trust instead of a Conduit Trust: Acceleration of the tax is a fait accompli. But the thought of pushing large sums of money into the hands of someone not ready to handle it (as is required when using a Conduit Trust) in addition to paying the tax is another thing entirely. An Accumulation Trust can accept the distributions while deferring payment to beneficiaries. Drafted properly amounts could remain in the trust, or be distributed to beneficiaries at set times, for designated needs or in the discretion of the trustee – providing stewardship and safety of principal. By properly timing trust payouts and the corresponding recipient the tax can be deferred until year 10 or recognized over the 10 years to spread the income and take advantages of lower tax rates.
§ Charitable Remainder Trust as a beneficiary to replicate the “Stretch IRA”: Designating a Charitable Remainder Trust (CRT) as the IRA or qualified plan beneficiary can approximate the results of a Pre SECURE “Stretch IRA”. On death of the IRA owner or plan participant the CRT is funded without resulting in payment of tax, with the individual’s estate receiving a charitable deduction for the present value of the expected future payment to the charity. The CRT then makes distributions of either a fixed amount or a fixed percentage of the value of the trust to the non-charitable beneficiary over time (e.g. a term of years or lifetime) at the end of which the remaining balance in the CRT goes to charity. Taxable income is recognized as the non-charitable beneficiary receives the distributions.
While this somewhat mirrors the functionality of the “Stretch IRA”, it is not an exact replacement – amounts remaining upon the death of the beneficiary go to charity instead of other family members. You achieve the stretch, but it comes with the price of disinheritance in the form of the contribution to charity. Not a problem if you are charitably inclined and feel you have sufficiently provided for your heirs. In that case the only person getting “disinherited” is the government- amounts go to charity avoiding tax on the remainder. If not, insurance on the life of the beneficiary (held outright or in trust) can be used to replace the “disinheritance”.
§ Role of insurance: In addition to supplementing the use of a CRT as a “Stretch IRA” replicant, it can offset tax due on the 10 Year payout. An Irrevocable Life Insurance Trust (ILIT) can be set up to hold insurance on the life on the IRA owner or plan participant. Upon death, proceeds will be paid income tax and estate tax free to the trust – offsetting income tax due on the required distribution. If structured properly, it can continue to provide economic benefit, as well as oversight and creditor protection to multiple generations on a tax favorable basis.
Roth IRA Conversions: With the 5 exceptions noted above, the 10-year post-mortem payout provisions of SECURE increase amounts distributable, accelerate their timing and taxation, and perhaps increasing the amount of tax if recipient beneficiaries are pushed into a higher tax bracket as a result of the distributions. While IRAs and qualified plans fall squarely within the scope of SECURE, Roth IRAs partially escape its reach. A Roth IRA not only grows free from tax, but its distributions are tax-free as well. Additionally, there are no lifetime RMD, so balances can be kept in a tax-free investing environment. They are, however, subject to the distribution provisions of SECURE after the death of the IRA owner or plan participant. So, while the acceleration does not increase taxes (distributions are tax-free), it does terminate the ability for balances to grow tax-free after year 10.
That said, a Roth IRA conversion may not be a bad deal if you
o Can convert in a year or over a term of years when your tax rate is less than the rate in the future distribution year(s)
o Recognized positive investment returns in post conversion years prior to the mandated SECURE distribution
Conversion needs to be undertaken mindfully with eyes wide-open, as there are several factors to consider. These include, but are not limited to, where the money will come from to pay the tax on conversion, assumptions as to tax law in the future, the length of time you can maintain the tax-free investment environment after the conversion (i.e. how long the IRA owner will live plus the 10 years).
Often things are not what they seem. And so it is with the SECURE ACT which in many respects makes us less secure by upending well thought out planning we have put in place. Like Toto we must ignore the exhortations to
“Pay no attention to that man behind the curtain!”
Wizard of Oz, The Wizard of Oz (August 25, 1939)
pulling back the curtain back and examining what is truly happening. From there we can adjust our planning to truly make things more secure for ourselves, and the people and the causes we care about.
As always, we we’re here at Intellectus to work with you and you advisors to explore and implement available planning strategies and ideas. Please don’t hesitate to reach out to any of us directly about opportunities available to you.
The attached information is presented for illustration purposes only, is not a representation of the recipient’s (or any person’s) actual or projected experience, and does not constitute professional advice or a recommendation to take, or refrain from taking, any action. The information is presented without obtaining specific professional advice from your attorney and/or CPA particularly with respect to tax planning. Intellectus Partners LLC and its affiliates, employees or agents disclaim liability for any consequences of your or others acting or refraining from acting in reliance on the attached information