The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, an expansive law that went into effect January 1, 2020, expands retirement savings opportunities to more people and accelerates tax revenues as a means to pay for the proposed changes. The elimination of the stretch provision for inherited Roth and traditional IRAs is among one of the significant changes to inheritance planning as a result of the SECURE Act.
The new law effectively eliminates the stretch IRA for inherited (non-spouse) IRA beneficiaries. Non-spouse IRA beneficiaries will be required to fully distribute the IRA to themselves by the end of the tenth year following the IRA owner’s death. The inherited IRA required distribution rules also apply to inherited Roth IRAs. While there is no tax on Roth distributions, the required ten-year distribution period will significantly reduce the tax-free growth the stretch would have allowed.
This change will also impact those who have named a conduit trust (most likely a revocable trust) as their traditional IRA beneficiary with the stipulation that the “look through” named beneficiary take RMDs from the inherited IRA. Under the SECURE Act, the only required distribution takes place in year 10 when the entire account must be distributed to the “look through” beneficiary.
There are several strategies that individuals can use to help offset the tax law changes such as Roth IRA conversion, life insurance, fund an irrevocable living trust, and make charitable contributions. Of the options, life insurance can be one of the most effective tools.
As an alternative to the stretch IRA, the IRA owner could utilize distributions from their IRA to fund a life insurance policy that would provide a tax-free inheritance to their beneficiaries. This could allow taxpayers to pay the tax on their IRA now at lower rates than their heirs would have to pay later in income and estate taxes. As an added benefit, the money in life insurance can grow tax-free and the proceeds from the policy would never be taxed.
Consider an example of utilizing life insurance as an alternative to stretch IRAs for a couple, both age 65 that have a desire to pass the value of their IRA to their children.
- IRA Balance: $1,000,000
- Annual IRA Withdrawals: $43,000
- Net After-tax Withdrawals (24% Tax): $30,000
For this example, let’s assume the couple does not need the full $30,000 net distributions for their normal living expenses and therefore used the money to fund a survivorship life insurance policy each year with a guaranteed tax-free death benefit of $1,868,840. The benefit of the survivorship life insurance policy is significantly more than the $1,000,000 IRA, minus taxes that their children would inherit. Also, there could still be money left in the IRA during their lifetime for other purposes. Assuming they both pass away at the age of 87, the IRA account will still have a value of $740,000* that they could pass to their children or use for other purposes.
For charitably inclined clients, there can be additional benefits of this strategy. The original IRA, less the amounts taken out to fund the life insurance, remains invested and continues to generate growth for the taxpayer’s spouse should he or she outlive the IRA owner. Since the owner replaced the value of the IRA with the life insurance policy, they could consider naming a charity as a contingent beneficiary of the IRA, allowing the couple (upon the death of the second spouse) to pass the balance of the IRA tax-free to charity.
This planning strategy uses distributions from a retirement account to fund a life insurance policy, potentially owned outside their estate if necessary, thereby leaving an income and estate tax-free inheritance to their children. Both the children and the charity could receive the benefit of this planning strategy.
With the significant changes to inheritance planning that was a result of the SECURE Act, it is best to connect with your Yeo & Yeo advisor to determine which alternative estate planning strategy may be best suited to meet your financial goals.
*The IRA value of $740,000 at age 87 assumes the annual withdrawals are the greater of $43,000 or the RMD amount and an interest rate of 4%.
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