“There’s almost always a reckoning when the government proffers a tax break. So it is with individual retirement accounts (IRA)s, 401(k)s and similar accounts that investors fund with pre-tax earnings.”
The SECURE Act of 2019 reset the game for IRAs and other tax deferred retirement accounts, says a recent article from Financial Advisor titled “IRAs, Taxes and Inheritance: Planning Becomes a Family Affair.” Prior to SECURE, investors paid ordinary income tax rates on withdrawals, whether they were voluntary or Required Minimum Distributions (RMDs) from these accounts, except for Roths. When individuals stopped working and their income dropped, so did the tax rate on their withdrawals. All was well.
Then the SECURE Act came along, with good intentions. The time period for payouts of IRAs and similar accounts after the death of the account owner changed. Non-spouse beneficiaries now have only 10 years to empty out the accounts, setting themselves up for potentially huge tax bills, possibly when their own incomes are at peak levels. What can be done?
Heirs of individual investors or couples with hefty IRAs and investment accounts are most likely to face consequences of the new tax regulations for RMDs and inheritances from the SECURE Act.
A widowed spouse faces the lower of either their own or the partner’s RMD rate—it’s tied to birth years. However, there is a pitfall: the widowed spouse files a single tax return, which cuts available deductions in half and changes tax brackets. Single or married, consider accelerating IRA withdrawals as soon as taxable income lowers early in retirement. Taking withdrawals from IRAs at this time voluntarily often means the ability to defer and as a result, optimize Social Security benefits to age 70.
For non-spousal beneficiaries of inherited IRAs, there’s no way around that 10-year rule. Their tax rates will depend on income, whether they file single or joint and any deductions available. If a beneficiary dies while the account still owns the assets, those assets may be subject to estate taxes, which are high.
Here’s where tax planning is could help. IRA owners may try to “equalize” inheritances among heirs with tax consequences in mind. For instance, a lower earning child could be the IRA beneficiary, while a higher earning child could receive assets from a brokerage account or Roth IRAs. Alternatively, an IRA owner could establish trusts or make charitable bequests to empty the IRAs before they become part of the estate.
Your estate planning attorney will help you create a road map for distributing IRA and other tax deferred assets based on the tax and timing for beneficiaries or what you want to fund after you pass.
Another strategy, if you don’t expect to exhaust your IRA assets in your lifetime, is to systematically withdraw money early in retirement to fund Roth IRAs, known as a Roth conversion. The advantage is simple: inherited Roth IRAs need to be drawn down in ten years, but the money isn’t taxable to beneficiaries.
Decumulation planning is complicated to do. However, your estate planning attorney will help evaluate your unique situation and create the optimal income sourcing plan for your family based on their assets, including taxable and tax-advantaged accounts, Social Security benefits, pensions, life insurance and annuities.
Reference: Financial Advisor (Sep. 29, 2022) “IRAs, Taxes and Inheritance: Planning Becomes a Family Affair”