Update estate plans for IRAs with these 3 steps

The SECURE Act, combined with recent IRS RMD rules, has upended the estate plans many clients have made for individual retirement accounts they will be leaving to their beneficiaries. Most non-spouse beneficiaries can no longer take advantage of so-called stretch IRAs and instead must withdraw the inherited retirement funds by the end of the 10^th year after death.

But it seems that many clients aren’t aware that the plans they made years or even decades ago may not work out as intended. The stretch IRA plan allowed designated beneficiaries to extend required minimum distributions over the life of the beneficiary, allowing a tax deferral on a large part of that inherited IRA for decades. That was the plan, but it likely won’t work out that way anymore.

3-Step Action Plan

Advisers need to step up and do three things:
1. Identify the clients whose beneficiaries will be most affected by the RMD rule changes.
2. Explain how the tax rules changed their plan, and why this may cause tax problems for their beneficiaries.
3. Show them alternative planning solutions.

The common theme here is to reducing taxable IRA balances now at today’s low tax rates.

IDENTIFY THE CLIENTS WHOSE BENEFICIARIES WILL BE MOST AFFECTED

How would an adviser know which clients will be most affected by the change in the tax rules? It will be the clients with the largest IRAs, since the larger the IRA balance, the more of those funds will be left to beneficiaries and the larger the potential tax problem for those beneficiaries. Most of the beneficiaries will have to pay all the tax within the 10-year term. In addition, some will be subject to RMDs for years one through nine after death. That will generally be the case when death occurs after the account owner’s required beginning date for RMDs.

Once you’ve identified the large IRA clients, then check the beneficiary forms for every IRA or other retirement account they have. The beneficiary form will tell you their current estate plan for those retirement accounts. If a beneficiary form can’t be found, set up a new one. Without a beneficiary designation, beneficiaries will be stuck with the least favorable payout options in most cases. Look also for clients who have named a trust as their IRA beneficiary, since many of those trusts will no longer work as planned and could end up subjecting beneficiaries to high trust tax rates.

EXPLAINS HOW THE RULES CHANGED THEIR PLAN, AND WHY THIS MAY CAUSE PROBLEMS FOR BENEFICIARIES

Once you’ve identified the clients most affected by the change in post-death IRA payout rules, explain to them why this is a potential tax problem and why their current plan may no longer play out as intended. By designating the named beneficiaries, the beneficiary form will reveal which post-death RMD rules will apply.

In a typical situation, when the named beneficiary is an adult child (or children), they will probably be subject to the 10-year rule and all the income tax will have to be paid by the end of the 10 years. If the beneficiaries are already in their high-earning years, that could result in more of those inherited IRA funds being eroded by taxes due to the short 10-year window.

ALTERNATIVE PLANNING SOLUTIONS

Now that clients are aware of the new RMD rules for their beneficiaries, it’s up to you, the adviser, to present alternatives that can put their plan back on track, and possibly improve it for better long-term results.

For example, converting to a Roth IRA could help by eliminating any income taxes for beneficiaries within the 10-year term. Inherited Roth IRAs must still be withdrawn by the end of the 10-year term, but there are no RMDs for years one through nine, so the funds can accumulate tax-free for beneficiaries for the full 10 years.

Of course, converting means paying tax upfront, but tax rates are at historic lows right now. Not every client will want to convert, but every affected client (the ones with the largest IRAs you’ve identified in step one above) should be advised to consider a Roth conversion, given the tax erosion that could occur when their beneficiaries inherit a traditional IRA. Roth IRAs can eliminate the trust tax problem as well, since distributions to the trust at the end of the 10 years will be income-tax-free, removing the potential high trust taxes that beneficiaries might otherwise be subject to.

Along the same lines as the Roth conversion approach is using permanent life insurance, which is a more flexible asset to leave to a trust or directly to beneficiaries. Life insurance has no post-death RMDs and no income tax.

The plan, similar to the Roth conversion, would be to withdraw traditional IRA funds now, pay the tax at today’s low rates and then use those funds (net, after-tax) to purchase a life insurance policy. This can provide both leveraged wealth transfer and tax-free payouts to beneficiaries and eliminate all the complex tax rules that now apply to inherited IRAs and IRA trusts.

Another way to bring down the IRA balance would be to use qualified charitable distributions for those clients who qualify and are charitably inclined. IRAs (but not Roth IRAs) are the best assets to give to charity since they’re loaded with taxes. It’s better for clients to leave their beneficiaries less in IRAs and more in non-IRA assets that can get a step-up in basis and be inherited income-tax-free.

Read more: Who keeps track of IRA basis?  

However, only IRA owners and beneficiaries who are age 70½ or older qualify for QCDs. QCDs are also limited to $100,000 per year, per person (not per IRA account). Most clients who currently give to charity are receiving no tax benefit for their gifts since they no longer itemize their deductions. Instead, they take the larger standard deduction. QCDs can fix that problem. While there’s still no tax deduction, the QCD provides an exclusion from income which is better than a tax deduction because it can lower adjusted gross income, which in turn can increase other tax benefits, deductions, or credits. With QCDs, the IRA funds are transferred directly from the IRA to the charity, but they aren’t included in income. This allows IRA funds to be withdrawn (transferred to charity) at a zero-tax cost.

The goal of all these planning strategies is to whittle down the taxable IRA balance at today’s low tax rates, leaving more to beneficiaries, and to protect against possible future higher tax rates.

These solutions may not be for every client, but every adviser needs to identify the affected clients, explain the new IRA estate planning problem, and present solutions like these that can lower the overall tax bill, especially for beneficiaries. Your clients’ current IRA estate plans need an upgrade now!

For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop, please visit www.IRAhelp.com.