You spend your entire career saving diligently for retirement. Fast forward 40 years, and now you’re carefully coordinating your beneficiary designations with the money you’re withdrawing for required minimum distributions (RMDs). Suddenly, BAM! Tax laws change. That inheritance you were leaving your children is now potentially a substantial tax burden once you die.
That’s exactly what happened in late 2019 when the SECURE Act passed. The law effectively eliminated the Stretch IRA, where you could leave a retirement account to a non-spouse beneficiary, and then they could stretch the RMD over their lifetime. This was incredibly useful when leaving IRAs to adult children who could stretch the RMDs over 30 years or more, as those years added significantly to the tax-deferred growth of the account.
The SECURE Act changed this planning strategy so that any inherited account was no longer subject to RMDs, but the account had to be depleted by 10 years after the original account owner’s death. For example, if your adult child inherits your IRA in his mid-40s, he is likely in the highest earning years of his career. Even spreading the withdrawals out over 10 years could still bump the heir into a higher tax bracket.
Let’s face it—there is no way to get around paying the tax on this money. It’s just a matter of when it’s paid and who pays it. Furthermore, no one knows when they will die. You may find that you need your assets for long-term care or that your heirs are retiring themselves putting them in a low tax bracket as well.
In 2020, the original account holder’s RMDs have been waived because of the coronavirus pandemic. This creates an opportunity for the original account owner to roll over a certain amount to a Roth IRA. Yes, the account owner would pay the tax due on the withdrawal, but with coordination between a financial adviser or CPA, the account owner could make sure to withdraw just enough to maintain a similar tax liability as previous years. When the Roth IRA is inherited by a non-spouse beneficiary, it will still need to be depleted by the 10-year deadline, but taxes would not be due on the withdrawals. This gives the beneficiary 10 years of potentially tax-free growth.
In subsequent years, the original IRA owner could continue to convert money to the Roth account, paying the taxes due. However, you need to consider the tax bracket of your beneficiary. If the heir is in a lower tax bracket, it may be better to leave the assets in the IRA, so when they are eventually distributed, they could be taxed at a lower rate.
One other option for the original account holder is to consider charitable distributions from the IRA. If the IRA owner doesn’t need the yearly RMDs for living expenses and normally donates cash to a favorite charity, he could make a charitable distribution from the IRA. The distribution would satisfy RMD requirements; the account owner would not be taxed on the distribution nor would he receive a tax deduction for the donation, and a qualified charity would not owe tax on the contribution.
Overall, leaving an inheritance for your heirs is a luxury, but remember, once your heirs receive the money, it is theirs to do with what they please and ultimately their tax burden. You may consider including your heirs in meetings with your estate planner, CPA, or financial adviser, and let the expert steer the conversation on the tax liability that comes with the windfall.
If you have questions on reducing the tax burden created by your tax-deferred retirement accounts, the experts at Henssler Financial will be glad to help: