For many, your IRA is the largest asset in your estate. Yes, even larger than your home or your investments. Why? Because you worked hard to save for retirement. You have dutifully contributed to your IRA over the years knowing that, not only is your IRA your safety net in retirement, but it is also a handsome nest egg that can be passed on for future generations. In the past, we have worked closely with clients to help them create estate plans designed to maximize the unique benefits of the IRA. However, that advice may be about to change.
First, What is an IRA?
An IRA is a tax-deferred retirement account that allows you to save pre-tax income for the future. Instead of paying taxes when you earn the income, your tax liability is deferred until you start receiving distributions at your retirement. This can be a huge financial benefit 1) because the tax deferral incentivizes saving and allowing your retirement funds to grow over years, and 2) you will likely find yourself in a lower tax bracket at retirement than you do right now.
Of course, not everyone retires at the same time. That's why IRAs require mandatory distributions begin at 70.5 years of age. These “Required Minimum Distributions” (RMDs) are calculated based on the average life expectancy of the owner and the amount held in the account. Because taxes were deferred when the funds were placed in the account, income tax is owed on all distributions as if they were regular income. As you age, the RMD gradually increases, as does your tax obligation.
IRA Estate Planning Today
Because IRAs are distributed based on average life expectancy, account owners may pass before withdrawing the full amount held in their IRA. When this happens, the IRA shifts the distributions to a designated beneficiary. Under current law, there are a number of ways that you can manage this distribution to minimize taxes paid and maximize benefit for your loved ones.
Married couples often plan to have the RMDs continue to be distributed to the surviving spouse whenever one passes. This allows the surviving spouse to continue to receive distributions as before and, in fact, they can be rolled into the surviving spouse's own IRA distributions, if he or she receives them. The IRA is recalculated based on the age of the surviving spouse, and this allows the IRA funds to “stretch” over the life of the surviving spouse. Depending on the age of the surviving spouse and any other income he or she may have, this arrangement can have a major impact on the surviving spouse's tax liability.
For beneficiaries who are not the IRA owner's spouse, it is also possible to stretch IRA distributions. Non-spouses who inherit an IRA have their RMD calculated based on their own age and the amount remaining in the account. For example, if a grandmother named her 25 year old granddaughter as the beneficiary of her IRA, the granddaughter would receive mandatory distributions from that account over many years. The same IRA designated for the benefit of the grandmother's 60 year old son would result in much higher monthly distributions (and, presumably, the son would have a greater tax liability if he is in a higher tax bracket than the 25 year old granddaughter).
IRA beneficiaries also have the choice to take their entire distribution in a lump sum. Of course, this triggers much higher tax liability and eliminates the benefits afforded by an IRA. That's why some IRA owners have chosen to name a trust as their IRA beneficiary, rather than an individual. By naming a trust, the IRA owner can exercise more control over when, how, and in what amounts a beneficiary can access his or her distributions. When a trust is named as an IRA beneficiary, it is treated as “see-through,” which means that the beneficiary's age still determines the amount of distributions.
How the SECURE Act Could Change Your Plan
In May 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act passed with widely bipartisan support in the House. It was expected to skate through the Senate as well but has been placed on “hold” for the time being. This bill — which includes a wide range of reforms — would be the first major retirement overhaul since 2006. The SECURE Act changes a number of aspects of retirement policy that may impact you, but here we are going to focus on the ways this bill could shift estate planning for IRAs.
The SECURE Act impacts estate planning by removing the option to “stretch” an IRA's distributions for non-spouse beneficiaries. If passed, this would be a significant change in the way IRA owners plan to pass on their accounts.
Under the SECURE Act, most non-spouse beneficiaries of IRAs will be required to withdraw the entire balance of the account within ten years of the death of the owner. Not only will this remove the benefit associated with “stretching” out the income over time, but it will also trigger significantly higher tax liability because the funds will be distributed in larger amounts. In fact, that is why this change was included in the SECURE Act. Analysts expect that this change will general $16 billion in additional tax revenue over the coming decade.
This shift may seem small, but it will have a major impact on those who have accrued substantial IRA balances. In general, lower-balance IRAs are liquidated fairly quickly after being inherited. However, larger IRAs have historically been a great way to pass generational wealth along to future generations without triggering substantial tax implications or the “windfall” effect.
Revisiting Your Estate Plan in 2019
If you have already created an estate plan based on the current IRA laws, we do understand your frustration. It can be hard to create a comprehensive and well-thought-out estate plan when the laws keep changing. However, changing legislation doesn't make an updated estate plan any less necessary. In fact, this potential shift in the legal landscape emphasizes a point that we make with all of our estate planning clients: estate planning is not a one-and-done event. It is a long-term commitment. Estate plans should be treated as living documents that adapt, shift, and evolve with changes in your wealth, family, and — indeed — the law.
If you have a trust named as the beneficiary of your IRA, or if you have been contributing to your IRA under the assumption that those funds would receive special tax treatment for your beneficiaries, let's talk. Give The Tyra Law Firm a call at (301) 315-0811.