Many American retirees are making significant mistakes with their traditional IRAs by planning to leave the accounts to their children or other heirs.
Inheriting a traditional IRA never was a great deal and is significantly less appealing to heirs now. An IRA owner can take actions to increase the value of inheriting the assets.
Most other assets are inherited income-tax free, plus the heir increases the tax basis to its current fair market value. The heir can sell the assets immediately and owe no capital gains or income taxes, no matter how much the asset appreciated during the previous owner’s holding period.
With a traditional IRA or other retirement account, there still are no immediate taxes when the beneficiary inherits it. But the beneficiary owes taxes on distributions as they’re made from the traditional IRA or 401(k) just as the previous owner would have.
A beneficiary really inherits only the after-tax value of a traditional retirement account.
Those always were the rules. The SECURE Act, enacted in late 2019, made an inherited traditional IRA even less attractive.
Before the SECURE Act, beneficiaries had to take required minimum distributions (RMDs) each year, but in many cases the RMDs could be spread over the beneficiary’s life expectancy. That limited the distributions and allowed the tax-deferred compounding of the IRA to work for a long time.
If the beneficiary wanted or needed additional money in any year, more than the RMD could be distributed.
This practice was called the Stretch IRA.
The SECURE Act eliminated the Stretch IRA for IRAs inherited after 2019. Now, most beneficiaries of traditional IRAs must distribute the entire IRA within 10 years, known as the 10-year rule.
There are exceptions to the 10-year rule for five types of beneficiaries: surviving spouses, beneficiaries under age 21, disabled or chronically ill individuals, and beneficiaries fewer than 10 years younger than the deceased owner.
The IRS made inheriting a traditional IRA even more complicated in final regulations that recently were issued. If the original owner of the traditional retirement account was taking RMDs at the time of death, the beneficiary must take annual RMDs for years one through nine after inheriting and fully distribute the account by the end of the tenth year.
The 10-year rules applies to inherited Roth IRAs as well, but the distributions are tax free and annual RMDs for years one through nine aren’t required.
For at least some years, the forced distributions from an inherited traditional IRA are likely to increase the beneficiary’s adjusted gross income enough to push the beneficiary into a higher income tax bracket. The distributions also might trigger or increase one or more Stealth Taxes, such as the Medicare premium surtax or income taxes on Social Security benefits.
The younger the beneficiary, the more significant the imposition of the 10-year rule is. For example, before the SECURE Act a 22-year-old beneficiary could spread distributions from the inherited IRA over 63 years.
The effects of the SECURE Act could be more onerous in the future.
The 2017 tax cuts are set to expire after 2025 if Congress doesn’t compromise on a plan to extend them for at least some taxpayers. In addition, the growing federal budget deficit and debt could lead to higher income tax rates for at least upper income taxpayers in future years. Taxpayers who are taking forced distributions from significant inherited IRAs are likely to become upper income taxpayers for at least a few years.
The SECURE Act changes don’t matter to beneficiaries who are going to spend inherited IRAs as quickly as possible.
The changes also don’t mean much to IRA owners who need their traditional IRAs to fund their retirement expenses.
But a substantial minority of retirees have enough income and assets outside their IRAs that the IRAs aren’t the primary source of retirement funding. They view the IRAs primarily as reserve accounts that primarily are to be left to their heirs.
Traditional IRA owners in that category should consider other strategies that will decrease the family’s income taxes and increase the after-tax wealth of beneficiaries.
By using one or more of these strategies, you can pay the income taxes on the traditional IRA, which is essentially a tax-free gift to the heirs. They’ll receive the full benefit of the inheritance instead of only the after-tax amount.
You also can plan when the taxes will be paid, which is likely to reduce the taxes paid.
Probably the most-used strategy is to convert all or part of your traditional IRA to a Roth IRA. You include the converted amount in gross income and pay income taxes on it, preferably using resources from outside the IRA.
Investment returns compound tax free in the Roth IRA and eventually are distributed tax free to you or the beneficiaries.
Another option is to take distributions from the traditional IRA when you’re in a relatively low tax bracket. This might occur during the early years of retirement before you begin RMDs. Or there might be years when you have reduced income or increased deductions.
Pay the taxes on the distributions and put the after-tax amount in a taxable investment account. You can invest the account to earn primarily long-term capital gains or other tax-favored income.
The advantage of the taxable account is, as I said earlier, when the heirs inherit they increase the tax basis of the assets to their current fair market value. There are no capital gains taxes on the appreciation that occurred in the taxable account.
Or they can continue to invest the account. They’ll owe taxes only on the capital gains and income earned after they inherited.
Another option is to reposition the traditional IRA as a permanent life insurance policy.
This is a flexible strategy that can be structured to meet your goals and needs.
You could withdraw the traditional IRA in a lump sum, pay the income taxes, and deposit the after-tax amount in a permanent life insurance policy.
Or you could take annual distributions, such as RMDs, and deposit the after-tax amount as annual premiums on a permanent life insurance policy.
Or the policy could be owned by an irrevocable trust. The trustee receives the proceeds from the policy after your death and then invests and distributes money according to the terms you set in the trust.
The insurance policy proceeds are tax free whether received directly by the heirs or by the trust.
For many people, the benefit paid by the insurance policy will exceed the pre-tax amount that was in the traditional IRA.
Another advantage of the insurance policy is the benefit paid to your beneficiaries doesn’t rise and fall with the markets. The benefit is either fixed or increases over time, depending on the type of policy you obtain.
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