Roth IRA

5 Things to Know about the SECURE Act

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What is the SECURE Act?

As you may be aware, a new law which significantly changes the way in which inherited retirement assets will be distributed to beneficiaries went into effect on January 1, 2020.  This is the SECURE Act.  While the SECURE Act includes some beneficial provisions such as increasing the age at which a participant must begin taking required minimum distributions from age 70.5 to age 72 and eliminating age restrictions for contributions to IRAs for individuals who continue to work, the significant downside to the Act is that it will require most beneficiaries of inherited IRAs or 401ks to withdraw all of the funds in the account within 10 years from the owner’s death.  This is a big change from the prior rules which permitted distributions over the life-expectancy of the beneficiary.  Read on for 5 Things to Know about the SECURE Act (and how it could impact your estate plan.)

  1. Your beneficiaries will realize less value from the inherited IRA under the SECURE Act. If you were counting on your beneficiaries receiving a certain amount from your estate which includes large IRAs or employer retirement plans, count again. Under the pre-2020 rules, an individual beneficiary could “stretch out” the withdrawal period over which he was required to take distributions over his life expectancy as of the death of the IRA owner.  Since the IRS assumes everyone is going to live until age 80 or so, this could mean a very long withdrawal period if your IRA was left to a child or grandchild.

For example, under the pre-2020 rules, a $1 million-dollar IRA inherited by a 50-year old beneficiary could be distributed to the beneficiary over approximately 30 years.  This means that in the first year the beneficiary would be required to withdraw about $33,000 from the $1 million IRA and include that amount in his taxable income.  The remaining $966,666 that was not withdrawn would continue to grow tax free.  Assuming a modest 5% growth, the balance at the end of the year would be $1,015,000. The following year the beneficiary would have to withdraw 1/29th of the balance in the IRA, or about $35,000 from that IRA. Again, the amount that was not withdrawn, about $980,000 would continue to grow tax free during that year and at 5% would be $1,029,000 at the end of the second year, and so on.

Under the SECURE Act rules for inherited IRAs, most beneficiaries will be required to withdraw the entire balance of the IRA within 10 years of the owner’s death.  Applying the new rules to the above example means that if the beneficiary withdraws 1/10th of the IRA the first year, she would withdraw $100,000 and pay income tax on that amount. The remaining $900,000 would continue to grow tax free during the year.  Assuming a 5% increase, this leaves a balance of $945,000 at the end of that year. If the beneficiary took out 1/10th the second year, that would be a withdrawal of $94,500 leaving a balance of $850,000, and so on.

  1. There are no changes in the distribution rules for a surviving spouse. While the rules regarding inherited IRAs for most beneficiaries have changed, they have not changed as to a surviving spouse. If you leave your traditional IRA or 401k to your spouse, your spouse will have the option to roll it over into his or her IRA and defer required minimum distributions until age 72. If your spouse is already age 72 or upon reaching age 72, the surviving spouse will be able to take withdrawals over his or her then life expectancy. It is only when the surviving spouse dies and the IRA passes on to the remaining beneficiaries, such as your children, that the 10-year rules come in to play and should be considered in your inheritance planning.

 

  1. If your IRA is payable to your Trust it gets more complicated. If you require more complex trust planning or you have structured your estate plan to leave your assets to a Trust for the benefit of your children following your death to provide asset protection for their inheritance or to control the distribution of the funds to them, then this change in the law is even more complicated. The reason for this is that distributions from the IRA are income taxable to the beneficiary.  If the beneficiary is a Trust, then the Trust will be responsible for reporting as income the distributions from the IRA and paying the income tax unless the distribution from the IRA is distributed out of the Trust to the beneficiary in the same tax year, in which case the beneficiary will report the income on her income tax return and pay the tax.   The problem is that the income tax rates on Trusts are much higher than on individuals.   An individual taxpayer reaches the highest federal taxable rate of 37% when she has taxable income of approximately $510,000. A Trust reaches that highest taxable rate when it has income of about $13,000.   Since no one wants to pay more tax than is necessary, logic dictates that the distribution from the IRA be distributed out of the Trust to the individual beneficiary.  However, once the funds are distributed to the beneficiary, the money is subject to the easy reach of the beneficiary’s creditors such as a divorcing spouse, a bankruptcy, a lawsuit or other creditors.  In addition, funds distributed out to the Trust to the beneficiary may be spent as the beneficiary pleases which may not be in accordance with your estate plan goals.

 

  1. IRAs passing to minor children may be paid out over the child’s life expectancy, but this comes with a price. Under the SECURE Act, if your IRA passes to your minor child, then the distribution can be stretched out over the minor’s life expectancy during the child’s minority.  (Note that the special stretch out rules for minors apply ONLY to the minor children of the IRA owner; they do not apply to step-children, grandchildren, or nieces and nephews).  Once the child reaches the age of majority, the 10-year rule applies.  There are many challenges associated with this new rule.  For example, a minor should never be designated as the direct beneficiary of an IRA.   Aside from the fact that most people don’t feel comfortable having assets pass into the hands of a young beneficiary, if a minor is named as the beneficiary of an IRA, then a court proceeding called a Conservatorship will be required. This is expensive and time consuming and best avoided.  The best practice is to leave an IRA to a minor beneficiary via a Trust.  In order for a Trust to be eligible for the life expectancy payout for a minor under the new rules, the Trust must direct that the required minimum distributions be distributed out of the Trust to the minor beneficiary immediately.  This may not be such a big deal while the beneficiary is a minor and the minimum distributions are calculated based on his then life expectancy.  Further, the minor would have a guardian who will receive and apply the funds for his benefit.  However, once the beneficiary reaches the age of majority (which, by the way, under the SECURE Act could be any time between the ages of 18 and 26), requiring that the IRA distributions be distributed out of the Trust and into the hands of the beneficiary could be a significant problem.

For example, if a $1 million IRA is left to a Trust for the benefit of a minor child who is 10 years old at the death of the parent, then the required minimum distribution the first year would be about $14,300.  This amount would have to be distributed out of the IRA to the Trust and then out of the Trust to the beneficiary, or his guardian.  Because of the small amount that must be distributed during the beneficiary’s minority, the balance in the IRA is likely to be $1.3 million or more when the beneficiary reaches the age of majority.  At that point, the balance in the IRA must be distributed to the beneficiary within 10 years.  The Trustee will have the difficult task of deciding on the timing of the withdrawals from the IRA.  Is it better to give an 18-year old $130,000 each year for 10 years, or should the Trustee defer taking withdrawals from the IRA until the beneficiary is older, and hopefully wiser, even if doing so will mean a larger tax liability?  These are hard decisions and will need to made on a case by case basis.  Given the requirement that IRA distributions be distributed out of the Trust to the beneficiary in order to obtain the stretch-out during the child’s minority, parents with large retirement assets may choose to forgo the stretch-out in favor of granting the Trustee discretion to retain withdrawals from retirement accounts in the Trust.

  1. If you have a Roth IRA, this change is actually beneficial. Under the old rules, inherited IRAs, including Roth IRAs, had to be paid out either within 5 years of the owner’s passing, or over the life expectancy of the beneficiary.  The life expectancy option was almost always the best choice as it minimized the taxes and maximized tax-free growth.  However, the life-expectancy withdrawal method required that every year beginning with the year after the death of the IRA owner, the required minimum distribution calculated on the beneficiary’s then life expectancy be distributed out of the IRA to the beneficiary.  Under the new 10-year rule, the entire amount of the IRA must be distributed by the end of the 10th year following the death of the owner; however, a beneficiary is not required to take the distributions in equal installments.  Since distributions from a Roth IRA are not income taxable to the beneficiary, a person who inherits a Roth IRA under the SECURE Act can refrain from taking any distributions for 10 years and allow the value of the Roth IRA to grow tax-free for that 10-year period.  After 10 years, the beneficiary will be required to withdraw the entire balance from the Roth but the amount withdrawn is not taxable income to the beneficiary since distributions from a Roth are income tax free.

The bottom line is that everyone who has significant retirement assets should review their estate plan with an experienced estate planning attorney who is familiar with the provisions of the SECURE Act, to understand the impact the Act will have on the distribution of these assets to their beneficiaries.  We are happy to review this with you and encourage you to be in touch to schedule a time to meet with one of our attorneys to evaluate how the enactment of the SECURE Act will affect your family and your estate plan.

Attorney Suzanne R. Sayward is a partner with the Dedham firm of Samuel, Sayward & Baler LLC which focuses on advising its clients in the areas of estate planning, estate settlement and elder law matters. She is certified as an Elder Law Attorney by the National Elder Law Foundation, a private organization whose standards for certification are not regulated by the Commonwealth of Massachusetts.  This article is not intended to provide legal advice or create or imply an attorney-client relationship. No information contained herein is a substitute for a personal consultation with an attorney. For more information visit www.ssbllc.com or call 781/461-1020.

Febraury, 2020

© 2020 Samuel, Sayward & Baler LLC

Using Roth IRA Accounts to Supercharge Bequests

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By Kevin Cotton and Steven Joshua Samuel, JD, MBA, AIF® Roth IRA accounts allow a taxpayer to contribute after tax money to an account which is never taxed again. The popularity of Roth accounts has grown and presents unique opportunities for retirement and for supercharging bequests to family or friends after the lifetime of the original owner. Converting Pre-tax Assets Eliminates Future Taxation Some people are fortunate enough to accumulate amounts of money in retirement that are more than enough for their own spending needs. For those taxpayers, converting some of the assets from a traditional IRA to a Roth IRA offers major advantages. Conversions to Roth IRAs are most commonly done with traditional IRA assets, but some 401(k) and other employer sponsored retirement plans even allow for “In-Plan” conversions. Converting money in a traditional IRA to a Roth IRA does require payment of income taxes. However, paying taxes upfront allows assets to then grow tax-free forever.  And, the Internal Revenue Code does not require minimum distributions at age 70.5 from Roth IRAs as it does from traditional pre-tax accounts. It is best to pay the tax using cash not in the traditional IRA for two reasons:
  1. So that the entire pre-tax balance is converted, ultimately increasing the after-tax value.
  2. To avoid the early withdrawal penalty on taxes paid from the Traditional IRA when the IRA owner is under age 59 ½ at the time of the conversion.
For taxpayers who intend to pass gifts to future generations, a Roth IRA can magnify the gift. Magnifying Gifts to Future Generations with Roth IRAs Roth accounts (or converting traditional IRAs to Roth) can be very effective as an estate planning and wealth transfer tool, especially if gifts to younger people are important goals. Since Roth IRAs do not require owners to take required minimum distributions, the account balance will continue growing and can ultimately result in a much higher balance being transferred to the named beneficiary after the original owner’s death. When a Roth is transferred to a younger beneficiary at death, the Roth becomes the beneficiary’s account. Some factors make the inherited account extremely valuable. Withdrawals from inherited Roth accounts are always free of penalty and are generally tax-free to the beneficiaries. Please note that inherited Roth IRA distributions may be subject to tax if it has been less than 5 years since the original Roth IRA owner funded his or her first Roth IRA. Although required minimum distributions do not apply to original owners of Roth accounts, they do apply to inherited accounts. However, required distributions are taken based on the heir’s life expectancy rather than the original owner’s life expectancy. For this reason, younger people will ultimately have a much higher balance inside the Roth, growing tax-free forever. Two examples of the magnifying effect of gifting a Roth IRA to a younger person follow below. Real Life Scenarios Bob, age 65, is considering leaving his $50,000 traditional IRA to his daughter, Jane, or grandson, Jack. He wants to know whether converting his traditional IRA to a Roth and paying the taxes on the conversion is a better idea. If Bob chooses the Roth conversion, he will pay the necessary tax with money outside of the IRA so that the full $50,000 balance is converted. This will cost Bob anywhere from $5-15,000 depending on his tax bracket, but see below for how well the Roth rewards that sacrifice. Scenario 1:
  • Assuming a 6% annual growth rate, the $50,000 Roth account balance grows tax-free (without required distributions) to approximately $127,021 at the time of Bob’s death at age 80.
  • Compare the Roth total of $127,021 with what would happen without the Roth conversion. The traditional IRA requires distributions starting in the year Bob turns 70.5 and would grow to only approximately $79,500 at the time of Bob’s death at age 80.
  • Jane inherits the $127,021 Roth account at age 45. Jane now enjoys tax-free growth and is only required to take out small annual required distributions based on her longer life expectancy.
  • Jane sees the inherited assets as additional retirement savings and lets the balance grow. At age 65, the Roth account grows to approximately $200,909, compared to only $125,746 if Jane had inherited a traditional IRA.
Scenario 2:
  • Assuming a 6% annual growth rate, the Roth account balance grows tax-free (without required distributions) to approximately $94,917 at the time of Bob’s death at age 75. The similar traditional IRA requires distributions starting in the year that Bob turns 70.5 and grows to approximately $75,392 at the time of Bob’s death at age 75.
  • Jack inherits the $94,917 Roth account at age 10. Jack now enjoys tax-free growth and is only required to take out small annual required distributions based on his longer life expectancy.
  • Jack sees two possible uses for the inherited assets: college expenses and the purchase of a home:
  • At age 18 and assuming a 6% annual growth rate, the Roth account grows to approximately $129,373, compared to only $102,763 for the similar inherited traditional IRA
  • At age 40 and assuming a 6% annual growth rate, the Roth account grows to approximately $312,907, compared to only $248,541 for the similar inherited traditional IRA
Notes: The above estimates assume 6% annual growth, 25% total taxation on all withdrawals, 15% total taxation on investments, and that RMDs are taken at the end of each year. These are hypothetical examples and are for illustrative purposes only.  Actual performance and results will vary. As the figures show, using Roth assets as a wealth transfer tool can be a very effective way to increase the value of a gift over time to a younger beneficiary. Since the inherited account does not have restrictions on withdrawals, the increased value can be a useful source of funds for various important goals in a beneficiary’s life. As always, consult a trusted financial advisor before implementing investment strategies. Samuel Financial LLC is located at 858 Washington Street, Dedham, MA 02026 and can be reached at 781.461.6886.  Securities and advisory services offered through Commonwealth Financial Network, member FINRA/SIPC, a registered investment adviser. Fixed Insurance products and services offered through CES Insurance Agency.

Estate Planning Considerations for Retirement Accounts

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These days, I see fewer and fewer clients with pensions that pay them a monthly income for their lifetime, and perhaps for their spouse’s lifetime as well.  Most of my clients now have large retirement accounts to which they and perhaps their employer have contributed.  These accounts may be in the form of a 401k, 403b or other retirement savings plan through a current employer, a rollover IRA (holding funds rolled over from a former employer), an inherited IRA (holding funds from an IRA of which the client was named as beneficiary) or a traditional IRA or Roth IRA established by the individual client.    These types of assets all have certain things in common – the funds in them have for the most part not been subject to income tax (with the exception of a Roth IRA), they are subject to specific and detailed rules for withdrawals during the lifetime and after the death of the account owner, and they often comprise a large percentage of the account owner’s wealth.  These factors combine to make it extremely important for clients to pay close attention to how they plan for these accounts.

As an estate planner, my goal is to make sure that the designated beneficiaries of my clients’ retirement accounts are consistent with the rest of their estate plan, that if someone becomes incapacitated his or her retirement funds can be appropriately managed, and that when the account owner dies these valuable assets are properly administered.  Most people diligently designate their spouse as the primary beneficiary of their retirement accounts, but many people do not designate contingent beneficiaries on their retirement accounts.  Admittedly, the contingent beneficiary designation is a much harder exercise.  Should you name a charity, your children, your grandchildren, your second wife, your Trust?  What if your desired beneficiaries are young and have no idea what a retirement account is?   The decisions that must be made when designating beneficiaries can have far-reaching income tax, estate tax, and other implications for you and your beneficiaries.

Further, many people are not aware that when they die, a non-spouse beneficiary must begin taking minimum required distributions from an inherited retirement account by the end of the year following the year in which the account owner dies.  This holds true whether the beneficiary is age 2 or 72, and leads to the important discussion of how to designate the beneficiary of your retirement account if you want to benefit young children.  There are pros and cons and tax considerations to deciding whether to name the child individually, or a trust for the child’s benefit, as beneficiary.

It is of course important to get good financial advice about how your retirement accounts are invested.  Many of these plans are now self-directed, with on-line tools to help you pick investments that are appropriate for your age and goals.  However, if you have a retirement account with several hundreds of thousands of dollars in it, you really should have a conversation about your investments with a human, preferably an experienced financial advisor, rather than your computer.

While you are dreaming about how you will spend that money in retirement (hopefully on living well, doing good, and having great adventures), take some time to consider what will happen if you do not outlive your retirement funds (which is the goal, after all).  Consult with an experienced estate planning attorney for advice on how best to plan for those retirement funds consistent with your estate planning goals so that the next generation can continue those dreams!

January, 2018

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