Editor's note: Just last week, 401(k) Specialist, among other publications, noted that several U.S. Senators are piping up about the Setting Every Community Up for Retirement Enhancement, or SECURE, Act, a bipartisan proposal that passed the House in May by a vote of 417-3, but has languished since. GOP Sen. Tim Scott, of South Carolina, wrote to Senate Majority Leader Mitch McConnell (R-Ky..), urging immediate Senate consideration of the SECURE Act. Scott was joined by Rob Portman (R-Ohio), who had previously advocated for moving the bill forward, as well as fellow Republicans Susan Collins (Maine), Joni Ernst (Iowa), Cory Gardner (Colo.), Martha McSally (Ariz.), and Thom Tillis of North Carolina. The bill is generally seen as encouraging more coverage for workers nationwide, 401(k) Specialist notes in its blog.
By Ashok Ramji
Forecasting whether or not the SECURE Act legislation will become law is impossible to say. If enough of these proposals do go through, our nation will see the most significant changes to the retirement planning landscape since the enactment of the Pension Protection Act of 2006.
Since the SECURE Act cleared a significant legislative hurdle with its overwhelming passage out of Congress' lower chamber, and our job as planners is to be anticipatory, we will focus on this bill's ramifications as they pertain to the stretch distribution strategy for an individual retirement arrangement (IRA).
Under current law, the "stretch" is available for spouse and non-spouse beneficiaries (like children and grandchildren) as well as for qualifying trusts. If eligible under IRS rules and regulations, the stretch allows beneficiaries to take distributions over their life expectancies after the IRA owner's death.
For deaths after 2019, the language of the SECURE Act maintains the stretch only for "eligible designated beneficiaries." This class of individuals is limited to five categories: the surviving spouse, minor children (but not grandchildren) up to the age of majority, a beneficiary meeting the IRS' strict standard of disability, a beneficiary who is chronically ill, or a beneficiary not more than 10 years younger than the deceased account owner.
For those beneficiaries not falling under one of these five classifications, as the saying goes, there is "no stretch for you!" The entire balance of the inherited IRA would have to be distributed by the end of the 10th year after the death of the owner. Distributions from the end of years one through nine would be optional.
Consider the balance of a traditional IRA account that is about $500,000 in pre-tax assets. Assume that the IRA owner dies after 2019, that the IRA was inherited by one non-spouse beneficiary who did not meet any of the other four criteria listed above, and an annual distribution of $50,000 over the next decade. This yearly withdrawal of $50,000 would be subject to ordinary income tax rates. Hopefully this additional amount of income would not push the beneficiary into a higher marginal tax bracket. Even though it is taxable, the beneficiary might be appreciative to have the extra income to help pay expenses, build savings, or maybe even buy a boat.
What if this IRA balance was twice as large? Holding assumptions constant, the non-spouse beneficiary would have to distribute $100,000 per year over 10 years after death or distribute the entire balance in one fell swoop by the end of year 10, all at prevailing ordinary income tax rates. The larger the IRA balance, the more thought that needs to be put into the beneficiary designation process. A 75 year-old spouse who lives to 95 could maintain the tax deferral far longer than a non-spouse beneficiary (who is half the spouse's age) and must distribute the assets in 10 years.
From the perspective of the IRA owner with the large IRA balance, s/he having built an asset of significance likely desires post-death control as well as minimization of taxes. Control comes not from designating an individual as beneficiary but could come from designating an entity like a trust.
As Ed Slott likes to say, "You use a trust when you don't trust!" If a qualifying trust meets certain "see through" or "look through" requirements under current law, the IRA account could be distributed over the life expectancy of the trust beneficiary. If the trust has multiple beneficiaries, then the stretch will be determined using the age of the oldest beneficiary. But, under the provisions of the SECURE Act, a trust is not considered one of the "eligible designated beneficiaries."
This issue is magnified for one type of IRA trust in particular called a conduit trust. This type of trust does not pay any income taxes because the required minimum distributions (RMDs) are distributed to the beneficiaries and taxes are paid at their own personal rates. The SECURE Act would have the conduit trusts distribute the assets in full by the end of the 10th year after death. The payout in full to beneficiaries one decade after passing defeats the purpose of using a trust to control the asset from the grave.
A product closely related to the conduit trust is the trusteed IRA. Many, but not all, financial institutions offer these to clients and those that do use them generally have IRAs with large balances. IRA analyst Sarah Brenner notes that "the IRA itself becomes a trust with the financial organization acting as the trustee. The account is administered under the trust provisions both before and after the IRA owner's death." While it is less expensive than paying an estate attorney to draft trust documents, the trusteed IRA will perform in the same manner as the conduit trust with assets distributed by the end of the 10th year after death.
There is one other type of IRA trust altogether different form the conduit, and that is the discretionary trust. Here the trustee has the discretion to pay out funds to trust beneficiaries or to instead keep the funds in the trust.
Note that funds held in the trust would be taxed at high trust tax rates. In 2019, income over $12,750 in a trust is taxed at 37%. The owner of the IRA is able to retain control but at a very high cost. Either the trust, at high trust tax rates if the funds remain in the trust, or the individual beneficiaries at their own rates will have to pay the taxes. Of course. if the funds are paid to the beneficiaries, they will no longer be protected in the trust.
With conduit and discretionary IRA trusts, the situation is like a tug-of-war. The account owner can set up a trust with no taxation at the trust level but no control (the conduit trust) or high taxation at the trust level with control (the discretionary trust).
Fortunately, there are a few approaches for IRA account owners to still have post-death control and minimize taxes. Converting to a Roth IRA may be a good strategy for IRA owners who want the control that a discretionary trust offers. By paying the tax upfront, the IRA owner eliminates the trust tax problem after death. Payments from the inherited Roth IRA to either the trust or the beneficiary would be income tax-free. The tax rate regime instituted under the Tax Cuts and Jobs Act is scheduled to sunset in 2025. Among the other considerations the IRA account owner would have to make, the taxes could be paid over the next years while tax rates are historically low.
Another viable strategy to maintain control and keep taxes low is to draw down the IRA balance during the owner's lifetime and invest the after-tax funds into permanent cash-value life insurance. Such life insurance is generally a more flexible and customizable asset to leave to a trust. Life insurance trusts can simulate the stretch IRA over any payout period desired. Except for annual investment income, the life insurance proceeds paid to the trust will be income tax-free to beneficiaries. If it is set up outside the estate, life insurance can also be estate tax-free. There are pluses and minuses to any approach, and this one is no different. In this case, the IRA owner would best earmark these funds for long-term use for the beneficiaries and be satisfied with limited access to these funds during his or her lifetime.
The fate of the SECURE Act is still unknown at this time, and it's quite possible that the stretch will be preserved if the Senate takes no action. One of the benefits of being part of the Ed Slott Elite IRA Advisor study group is that we can take an avant-garde approach to tax, retirement, and estate planning. Looking at the big picture demographically, we are at a phase when an increasing number of boomers are taking their required minimum distributions from tax-deferred accounts. The stock market's decade-long expansion has generally resulted in higher account balances, which gets the attention of a revenue-hungry Congress with a trillion-dollar budget deficit gap to fix.
Legislation designed to end the stretch keeps the IRA's purpose more as a retirement planning tool and less as an estate planning vehicle. Should new post-death IRA rules force beneficiaries to distribute assets over a decade instead of the remaining life expectancy, there are still approaches available today to give the IRA owner what s/he ultimately wants: control of the asset with minimum taxation. Work with a licensed and competent professional, well versed in these matters, to help you make decisions that are in the best interest for you.
About the author: Ashok S. Ramji, CLU, ChFC, is a licensed life insurance professional with TOP Planning LLC in Washington state. He is an investment adviser representative with Insight Folios Inc. and a member of Ed Slott's Elite IRA Advisor Group. He works with clients at or nearing retirement to put market volatility in its place to generate steady and predictable income.