More Ways to Lessen the Impact of the SECURE Act

In our previous newsletter, we looked at how the 2019 SECURE Act changed the rules for heirs of retirement accounts—specifically, how a new clause requires that a benefi­ciary deplete their inherited account within 10 years after the original owner’s death (as opposed to over multiple decades).

Compressing the distri­b­ution schedule to just 10 years has the potential to force dollars out of the inherited retirement account at a higher tax rate.

Here, we will consider a few more strategies for minimizing this negative impact—and maximizing the after-tax value passed to heirs.

Add Beneficiaries to the Account

Under the new rule, an account owner can’t spread the distri­b­ution of funds over more than 10 years, but they can distribute the funds to more benefi­ciaries. Naming children and grand­children as primary benefi­ciaries (if they are adults filing their own tax returns) may help minimize the cumulative impact of income taxes.

Account owners following this strategy should be aware that pre-tax distri­b­u­tions to young benefi­ciaries are treated as unearned income and may be subject to the Kiddie Tax (equiv­alent to the parent’s marginal tax rate). In this case, the benefits of adding a grand­child as a benefi­ciary may be lost if the child is very young.

Weigh Beneficiaries by Tax Bracket

Generally, distri­b­u­tions from inherited Roth accounts will be tax-free to benefi­ciaries, regardless of their tax situation. This is not the case for pre-tax retirement accounts left to benefi­ciaries in different tax brackets. A higher income tax rate equals a lower after-tax value relative to heirs in a lower tax bracket.

While splitting assets equally among children may sound like an equitable strategy, it could leave heirs with very different after-tax values. Consid­ering after-tax values among heirs when distrib­uting pre-tax, after-tax, and tax-free accounts like Roth IRAs could lead to more tax-efficient distributions.

Bypass A Spouse

For married couples, another strategy is to pass some (or all) of pre-tax retirement accounts belonging to the spouse who dies first directly to benefi­ciaries. The portion of the account that skips the surviving spouse will start the 10-year clock to deplete the account. When the second spouse dies, a second 10-year clock will begin to deplete the second account inherited from the surviving spouse. This means a couple could poten­tially give their benefi­ciaries as many as 20 years to spread out distributions.

Consider a Roth Conversion

A straight­forward strategy for minimizing taxes to benefi­ciaries is to convert pre-tax retirement accounts to Roth IRAs. This approach makes sense in situa­tions where the tax rate paid on the converted amount would be less than the tax rate paid by the benefi­ciary. These conver­sions can be done over time to spread out and minimize income taxes for the account owner.

The key objective is to get distri­b­u­tions out of pre-tax accounts at the lowest possible tax rate. Distri­b­u­tions can still be spread over the lifetime of the owner, even though they can no longer be spread over the lifetime of the beneficiary.

When deciding how to respond to the new 10-year rule, the first step is to review all benefi­ciaries and determine how they might be impacted by the rule. See if any of the strategies we have outlined here apply to your situation. While the best decision may be to do nothing, in some cases these approaches are more effective than simply spreading the dollars out across the allotted 10 years.

Rick’s Insights:

• Young benefi­ciaries may become subject to the Kiddie Tax from pre-tax distri­b­u­tions made from an inherited retirement account.
• A beneficiary’s higher income tax rate equals a lower after-tax value relative to heirs in a lower tax bracket.
• Distri­b­u­tions can still be spread over the lifetime of the account owner, but they can no longer be spread over the lifetime of the beneficiary.