By Nicole Gopoian Wirick, CFP
There’s nothing like a global pandemic to make you pause and evaluate your own mortality. There aren’t many silver linings, however, one might be that COVID-19 caused many Americans to reevaluate their legacy planning goals with an increased sense of urgency.
Recently passed legislation (the SECURE Act) and potential new legislation (Tax Reform Bill) significantly influences how your financial plan might address multi-generational wealth transfer and legacy planning.
Passed in December 2019, the SECURE Act considerably impacted the inheritance of IRA assets. Generally, most IRA owners name their spouse as primary beneficiary and their children as contingent beneficiaries if pre-deceased by their spouse. The Act mandates that most non-spousal beneficiaries must deplete an inherited IRA by the end of the tenth year after inheritance, eliminating the opportunity to stretch the inheritance over the beneficiary’s life expectancy. This means most non-spousal beneficiaries will pay more tax sooner and deplete inherited IRA accounts faster.
Let’s use an example to compare the inheritance of IRA assets by non-spousal beneficiaries pre- and post-SECURE Act:
Grandmother had a deep fondness for her grandson and decided to name him beneficiary of her IRA since her husband pre-deceased her and her daughter had amassed quite a bit of wealth in her own right. Grandson was 40 when grandmother passed away and she left him $1,000,000 in her IRA.
Pre-SECURE Act, grandson was required to take minimum distributions from this inherited IRA over his lifetime, based on his life expectancy. A 40-year-old individual would have to take 2.3% out of the inherited IRA in year one, paying ordinary income taxes on $2,300. Although the percentage grandson is required to distribute from the account increases each year as he ages and his life expectancy shortens, the planning goal was for growth to eclipse the distributions, enabling grandson to build wealth despite his required distributions.
Post-SECURE Act, grandson is required to take the entire $1,000,000 out of the account by the end of the tenth year after inheritance. There is no annual required minimum distribution, so he could take out 10% per year or wait until the tenth year to take the entire distribution (or anything in between). This option provides more flexibility, but also entails profound tax implications. Assuming grandson elects to distribute 10% per year, he would add about $100,000 to his annual income and increase his tax rate significantly (assuming no growth in the portfolio to keep the example simple).
Enter the potential Tax Reform Bill. Although we don’t know the exact terms of the bill, the new administration indicated a desire to increase income tax rates for income levels above $400,000. If grandson adds at least $100,000 to his annual income, he could risk entering the highest tax bracket. UGH! Grandson got hit with a double whammy:
1. An additional $97,700 of income ($100,000 – $2,300) taxed at ordinary income tax rates.
2. The additional income could push him into the highest tax bracket.
Assuming grandmother is interested in multi-generational wealth planning, let’s explore a few options:
Option 1: Grandmother could consider a Roth conversion. While this strategy might not appeal to grandmother during her lifetime given her age and tax bracket, the SECURE Act creates an opportunity to evaluate Roth conversions in a new light, especially given grandmother’s desire surrounding multi-generational wealth transfer.
Benefit: Once grandmother converts her IRA to a Roth IRA, she will avoid required minimum distributions for the remainder of her lifetime and the account will grow tax-free. When grandmother passes away and grandson inherits the account, he must still deplete the inherited Roth IRA by the end of the tenth year after inheritance, but can generate tax-free growth for ten years and then take a tax-free distribution at the end of the tenth year. A Roth IRA is likely a significantly better outcome for grandson.
Burden: Consider if grandmother’s plan provides enough free cash flow to pay the additional tax burden associated with the conversion since it’s optimal to pay such taxes with a source of money outside of the IRA itself. Perhaps grandmother will have to sell other assets to address this tax liability, incurring an even greater voluntary tax (i.e., if she sells stock in her trust account and recognizes the gain). Grandmother will recognize additional income which could impact her (i) Medicare premiums, (ii) Social Security taxability, (iii) additional Medicare Tax and net investment income tax and (iv) long-term capital gains tax rates.
Big Picture: Evaluate the importance of multi-generational wealth transfer and determine if the benefit of passing more tax-optimized wealth is worth the burden of incurring voluntary lifetime tax. Coupled with coordination between your financial planner, CPA and estate planning attorney, a comprehensive financial plan is a valuable tool to analyze the impact of a potential conversion.
Option 2: Let’s say grandmother decides not to convert her IRA to a Roth IRA during her lifetime due to tax implications. Instead, she would rather donate assets to charity as part of her legacy plan. Grandmother could consider naming the charity as IRA beneficiary and leave the taxable assets to her relatives so they realize a step-up in cost basis at her date of death (assuming a new tax bill doesn’t eliminate this provision).
Here’s how the step-up works: let’s say grandmother bought a share of stock for $100 in 2010 and it’s worth $200 in 2021. If grandmother sells the stock the day before she passes away, she would incur $100 of capital gains. If grandmother passes away and grandson inherits the stock, his cost basis steps up to $200. He would not incur any capital gains tax if he immediately sold the stock.
Benefit: Charities are great beneficiaries of traditional IRA assets! Unlike grandson, a qualified 501(c)(3) organization does not pay any tax on IRA assets; therefore, charities pocket more than individual beneficiaries when you consider the tax treatment. Importantly, this legacy planning opportunity excludes Roth IRAs because distributions are tax-free.
Burden: You must have strong philanthropic intentions since you will be shifting part of your inheritable assets away from your family members. Charities can change their missions over time so it’s important to reflect on exactly how you want your legacy dollars deployed and address such decisions as part of your comprehensive financial plan.
Big Picture: Determine or review who will inherit your assets at the end of your lifetime, look at the taxability of each asset and then collaborate with your financial planner, estate planning attorney and CPA to tax optimize your gift.
About the author: Nicole Gopoian Wirick, JD, CFP®
Nicole Gopoian Wirick, JD, CFP® is the founder and president of Prosperity Wealth Strategies in Birmingham, Michigan. Nicole is a fee-only financial planner who believes successful advisory relationships involve compassionate conversations coupled with planning tenacity.