My Three Sons: Equal Isn’t Always Optimal

The death of the stretch IRA makes customized inheritance planning an imperative for people who want to maximize money to family. Adviser Mike Lynch describes why equally to all isn't always the best strategy.
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By Michael Lynch, CFP

The SECURE Act, passed and signed into law in the waning days of 2019, upended traditional legacy planning relating to retirement plans. Since these never-taxed assets account for the bulk of most Americans non-real estate wealth, this is a big deal. For many, it’s a game changer that will result in a major tax hit if you don’t adjust.

Michael Lynch

Michael Lynch, CFP

Prior to this new “security,” the straightforward strategy for most Americans was simply to live off their IRAs and other retirement plans, paying taxes as they withdrew the funds. When a person no longer needed the money—that is, they needed an undertaker—the accounts could pass to the next generation. The key is that beneficiaries had the option to withdraw the funds over their life expectancy. This continued slow use of the funds allowed them to grow as well as smooth out the taxes paid. The slang for this strategy was “stretching” the IRA.

Death of a Tax Strategy

The SECURE ACT killed the stretch IRA for non-spouses, replacing it with a ten-year-and-out rule for people who inherited in 2020 going forward. There are no longer any required annual withdrawals, but the entire account must be emptied in ten years. If not, half the account plus taxes will head to DC.

Consider a $1 million IRA transferring to a 50—year old child. Under the old rules, she’d have to withdraw just over $29,000 in the first year after mom’s death. Over ten years, given a 6 percent rate of return, she’d withdraw $442,000. If the beneficiary had a household income of $150,000, she would pay just over $100,000 in taxes over a decade with plenty more to come in the future.

The account balance at that point would be $1,292,683. By her life expectancy at 84 she would have turned the $1 million of initial value into $3.6 million of withdrawals. She’d pay $950,000 in taxes. Seemed like a good deal for everyone, save mom, of course, who had to die for it.

The New Reality

Post-Secure Act, if she elected to take $100,000 out a year and the gains in year 10, she’d pay $378,000 in taxes – $278,000 more. The withdrawals would also move her up the tax brackets, eventually right to the top. If she waited until year ten, she’d withdraw $1.7 million and pay $590,000 in federal taxes. A loss of more than a third of the account.

Although customized inheritance planning was always advisable, the death of the stretch IRA makes it imperative for people who want to maximize money to family. I was struck by this recently when reviewing with a client his substantial IRAs. He and his wife live in a zero-tax state. They are practicing the planning of plentitude. They will likely leave substantial IRA inheritance to their three sons.

Three Sons, Three Strategies

This couple has an above average, if not burning, desire for their hard-earned money to benefit their boys. One son is a high earning executive. One earns an above-average income in a two-income household. The third is a bit of a free spirit and let’s just say income taxes are not a concern at this point. Each of the boys lives in a state that taxes income.

To optimize the after-tax value of the IRAs, we developed the following strategy for the $300,000 of funds that he and his wife knew they were not going to need for their own support.

The First Strategy

For the high earning son’s third of the inheritance, my clients would create an IRA and convert it to a Roth. This would create a taxable event of $24,000 for my clients, as it put them in the 24 percent bracket. I said send the bill to your son. He pays the $24,000 out of pocket. This is far lower than his combined tax rate of 44 percent. He has effectively bought out the IRS’s interest in his inheritance. The $100,000 now compounds for thirty years. You live 20 years and then there’s 10 years before it must be withdrawn. That $24,000 today generates $575,000 of tax-free money in the future.

Number Two

Son number two pays substantial taxes but does not have the funds to pay the tax on conversion. His financial plan shows that he will pay taxes on income throughout his life, so there is a value to tax-free future assets. For him, my clients convert to Roth and pay the taxes out of the conversion. There is no state tax, and this leaves $76,000 to invest. Over thirty years, this grows to $436,000 of tax-free money. This compares well to leaving it taxable, producing more than $100,000 more in after-tax money.

The Third Alternative

Son number three may face 99 struggles, but to misquote Jay-Z, “taxes ain’t one.” Therefore, his IRA should remain pre-tax. His parents pay higher taxes than he does and likely always will. Given the progressive nature of the tax code, he should be able to withdraw the funds starting in year 20 with a minimal tax drag.

The simple concept here is that families that plan and execute intergenerationally can expect more success than those who wing it. Laws are always changing creating the need to adjust. This is a simple example good family communication and tax-arbitrage (taking advantage of different tax rates) to produce big financial results. Feel free to contact me if you feel this type of strategic planning might benefit your family.

About the author: Michael Lynch, CFP®

Michael Lynch CFP is a financial planner with the Barnum Financial Group in Shelton CT and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. He can be reached at mlynch@barnumfg.com or 203-513-6032.

Securities, investment advisory and financial planning services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to complete or cover every situation, and should not be construed as legal, tax or accounting advise. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. CRN202304-282065


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